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Digitized  by  the  Internet  Archive 

in  2007  with  funding  from 

Microsoft  Corporation 


http://www.archive.org/details/corporationfinanOOIougrich 


MODERN   BUSINESS 


THE  PRINCIPLES  AND  PRACTICE  OF  COMMERCE, 
ACCOUNTS  AND  FINANCE 


PREPARED  AND  EDITED  UNDER  THE  DIRECT  SUPERVISION 

OF 

JOSEPH  FRENCH  JOHNSON,  A.B.,  D.C.S. 

DEAN  NEW  YORK  UNIVERSITY  SCHOOL  OP  COMMERCE,    ACCOUNTS  AND  FINANCE 
AUTHOR  "money  AND  CURRENCY,"   " SYLLABUS  OF  MONEY  AND  BANKING,"  ETC, 


Copyright,  1909 

BY 

DE  BOWER-ELLIOTT  COMPANY 


TABLE  OF  CONTENTS 


INTRODUCTION. 

CHAPTER  I. 
THE  CORPORATE  FORM. 

ECTION  PAGE 

1.  "  Non-Stock "    Corporations t..     .  1 

2.  **  Stock "  Corporations 2 

S.     Definitions 2 

4.  The  Fiction  of  "  Corporate  Entity/' 3 

5.  Corporations  in  Ancient  Nations 4 

6.  Popularity  in  Modern  Times 5 

7.  Adaptability  to  Raising  Large  Amounts  of  Capital  .      .  5 

8.  Permanence 8 

9.  Centralization  of  Control ».      .      .      .  9 

10.  Transferability  of  Ownership 10 

11.  Limited    Liability 11 

12.  Disadvantages  of  the  Corporate  Form 12 


CHAPTER  IL 
LEGAL  STATUS  OF  THE  CORPORATION. 

AS,     Defining  and  Controlling  Instruments      .,     ..      .      .      .  17 

14.  Common  Law  of  Corporations 17 

15.  The  State  Constitution 18 

16.  Method  of  Creating  the  Corporation 19 

17.  Essential  Features  of  the  Charter .  20 

18.  A  Sample  Charter 22 

19.  The  Corporate  Name 24 

20.  The   Corporate    Purposes 24 

21.  Other  Important  Features  of  the  Charter 28 

22.  The   By-Laws. 28 

23.  Essential  Features  of  the  By-Laws    .      .      .     ^      .      .  38 

vii 


viii  CONTENTS 

CHAPTER  III. 
INTERIOR  ORGANIZATION. 

SECTION  PAGE 

24.  Rights  of  Stockholders 37 

25.  The  Proxy  and  its  Uses 38 

26.  The   Right  to   Dividends 40 

27.  The  Right  to  Information 41 

28.  Liabilities  of  Stockholders 42 

29.  Rights  of  Creditors 44 

30.  "  Dummy "  Directors 44 

31.  Powers  and  Liabilities  of  Directors 45 

32.  The  Efficiency  of  Corporate  Organization 47 


CHAPTER  IV. 
WHERE  AND  HOW  TO  INCORPORATE. 

33.  A  Corporation  May  be  Chartered  in  Any  State  and  Do 

Business  in  Other  States 49 

34.  The  Regulation  of  "  Foreign  "  Corporations     ...      .51 
S5,     Choosing  the  State  of  Incorporation     ......  52 

36.  Comparative  Charges  in  Several  States 53 

37.  Liberality  of  Corporation  Laws  in  Several  States     .      .  55 

38.  Permanence  of  the  Laws 56 

39.  Reputation  of  Various  States 57 

40.  Comparative  Summary  of  the  Advantages  and  Disadvan- 

tages of  the  Important  States  of  Incorporation     .      .  58 

41.  Agreements  Prior  to  Incorporation 63 

4i2.     The  Wide  Range  of  Choice  in  Incorporation   ....  64 


CHAPTER  V. 
CORPORATE  STOCK. 

43.  Stock  Certificates  Not  Fully  Negotiable     .      .      .      .      .65 

44.  Par  vs.  Market  Value  of  Stock 68 

45.  Nature  of  Preferred  Stock 71 

46.  Uses  of  Preferred  Stock 73 

47.  Cumulative  Voting 75 

48.  Voting  Trusts ,.,     .      .  77 


CONTENTS  ix 

CHAPTER  VI. 
TYPES  OF  BUSINESS  CORPORATIONS. 

SECTION  PAGE 

49.  Further  Classification  of  Corporations      .      .      .      .      .  79 

50.  The  "  Parent "  Company ,     ....  81 

51.  Nature  of  a  Holding  Company 81 

52.  The    Holding    Company    as    a    Means    of    Organizing 

"Trusts" 83 

53.  Complexity  of  Holding  Companies 86 

54.  Organization  of  the  Standard  Oil  Company     ....  87 


CHAPTER  VII. 
THE  SOURCES  OF  CORPORATE  FUNDS. 

55.  Summary  of  Preceding  Chapters .  91^ 

56.  Four  Sources  of  Corporate  Funds 91 

57.  The  Investing  Public  as  a  Source  of  Funds     ....  93 

58.  Difference  Between  Investment  and  Speculation       .      .  94 

59.  The  Speculative  Public  as  a  Source  of  Funds     ,      ,      ,  95 

60.  Desirability  of  Borrowing  Funds 96 

61.  Distribution  of  Security  Issues 102^ 


CHAPTER  VIII. 
SHORT  TIME  LOANS. 

62.  Trade  Credit  as  a  Source  of  Funds 105 

63.  What  Reliance  Should  be  Placed  on  Bank  Loans  ?     .      .107 

64.  Notes  Sold  to  the  Public  as  a  Source  of  Funds     .      .      .114* 


CHAPTER  IX. 
THE  CORPORATE  MORTGAGE. 

65,  What  Determines  the  Value  of  Fixed  Assets?     .      «      .119 

66,  Nature  of  a  Mortgage  Bond       .      .  121 

67.  Essential  Features  of  a  Deed  of  Trust 122 

68.  Classification  of  Mortgage  Deeds  of  Trust     .      .      .      .125 


s  CONTENTS 

CHAPTER  X. 
TYPES  OF  CORPORATION  BONbS. 

SECTION  PAGE 

69.  Classification  of  Bonds 127 

70.  Mortgage  Bonds 129 

71.  Sinking  Fund  Bonds 130 

72.  Collateral  Trust  Bonds ,      .  133 

'73,     Equipment  Trust  Bonds 135 


CHAPTER  XI. 
TYPES  OF  CORPORATION  BONDS  {continued). 

74.  Debenture  Bonds 141 

75.  Income  Bonds 144 

76.  Other  Types  of  Bonds 147 

77-     Purposes^  Manner  of  Payment^  and  Conditions  of  Re- 
demption of  Bonds 149 

78.  Convertible  Bonds 151 

CHAPTER  XII. 
CORPORATE  PROMOTION  — THE  NEW  ENTERPRISE. 

79.  The  Function  of  a  Promoter 154 

80.  "Discovery"  of  a  Proposition 156 

81.  "  Assembling  "  a  Proposition 157 

82.  Financing  a  Proposition  —  The  Initial  Development     .  158 

83.  Foresight  in  Providing  Funds 160 

84.  Advantages  of  a  Wide  Distribution  of  Stock  .      .      .      .  l6l 

85.  "  Starting  Right  "  in  the  Sale  of  Stock l6l 

86.  A  Concrete  Illustration .  162 

CHAPTER  XIII. 
THE  PROMOTER  AND  THE  CORPORATION. 

87.  Professional  Promoters 167 

88.  Lawyers  and  Bankers  as  Promoters 169 

89.  Engineering  Firms  as  Promoters 169 

90.  Secret  Profits  are  Illegal 171 

91.  Misleading  Statements  Constitute  Fraud 174 


CONTENTS 


XI 


SECTION  PAGE 

92.  Contracts  on  Behalf  of  the  Corporation  and  Their  Ac- 

ceptance       175 

93.  The  Promoter's  Pay 175 

94.  The  Promoter's  Risks  and  Labors 178 

95.  Is  the  Promoter  Over-Paid? 178 

CHAPTER  XIV. 
CORPORATE  PROMOTION  —  FORMING  CONSOLIDATIONS. 

96.  The  Importance  of  Small  Industrial  Combinations     .      .180 

97.  Difficulties  in  the  Promoter's  Task 181 

98.  "  Discovery  "  of  a  Small  Consolidation 182 

99-  Basis  of  Consolidation 183 

100.  The  Necessity  for  Cash 190 

101.  One  Method  of  Raising  Cash 191 

102.  Problems  in  Forming  a  Large  Consolidation     .      .      .      .194 

103.  Basis  of  Consolidation .195 

104.  The  Interborough-Metropolitan    Consolidation     .      .      .196 

CHAPTER  XV. 
THE  UNITED  STATES  STEEL  CORPORATION. 

105.  Preparing  the  Ground 199 

106.  The  Steel  Consolidations  Preceding  the  Formation  of  the 

United  States  Steel  Corporation 200 

107.  A  Condition  of  Unstable  Equilibrium 201 

108.  Method  of  Promotion 205 

109-     Prospectus  of  the  Corporation 206 

HO.     Profits  of  the  Promoters 209 

111.  Capitalization  at  the  Beginning 209 

112.  Additions  to  the  Steel  Corporation 211 

113.  Financial  Changes    ...........   213 

114.  Basis  of  Capitalization 215 

115.  Operating  Policy  of  the  Corporation 218 

116.  Securities  of  the  Corporation  and  Their  Standing       .      .219 

CHAPTER  XVI. 

SELLING  SECURITIES  —  THE  PROSPECTUS  AND  THE 
BANKING  HOUSE. 

117.  The  Four  Methods  of  Selling  Securities  .      .      .      .      .223 

118.  General  Characteristics  of  a  Good  Prospectus     ^     .      .  224 


xii  CONTENTS 

SECTION  PAGE 

119.  A  Typical  Speculative  Prospectus  ., 226 

120.  A  Typical  Investment  Prospectus 228 

121.  The  Ideal  Prospectus 230 

122.  Selling  Through  Banking  Houses 231 

123.  Requirements  of  Reputable  Banking  Houses  .      .      .      .  232 

124.  Their  Methods  of  Selling  Securities     .      .      .      .      .      .235 


CHAPTER  XVII. 
SELLING  SECURITIES  — THE  WALL  STREET  MARKET. 

125.  The  Principal  Stock  Exchanges  of  the  United  States     .  239 

126.  Listing  Securities     ....     t.      .....      .  240 

127.  The  Curb  Market 242 

128.  Stock  Exchange  Methods 243 

129.  Importance  of  Speculative  Dealings 245 

130.  Buying  on  Margin 246 

131.  Selling  Short 247 

132.  Stock  Exchange  Houses  vs.  Bucket  Shops     ....  248 

133.  The  Classes  of  Wall  Street  Speculators 250 

134.  A  Summary  View  of  the  Stock  Market 251 

135.  Stimulating  Speculative  Interest 251 

136.  Syndicate  Operations 253 

137.  Stock  Market  Manipulation 254 


CHAPTER  XVIIL 
SELLING  SECURITIES  — THE  UNDERWRITING  SYNDICATE. 

138.  Origin  of  Underwriting 256 

139.  Advantages  of  Underwriting  to  the  Corporation     .      .      .  257 

140.  Advantages  to  the  Buyers  of  Securities 258 

141.  When  is  Underwriting  Advisable? 259 

142.  Why  Underwriting  Syndicates  are  Formed     ....  262 

143.  Three  Types  of  Syndicates 263 

144.  A  Fourth  Type  —  Pooling  the  Sale  of  the  Security     .      .  268 

145.  A  Fifth  Type  —  Distributing  the  Security     ....  265 

146.  The  Large  Underwriting  Houses 267 


CONTENTS  xiii 

CHAPTER  XIX. 
MANAGEMENT  OF  THE  UNDERWRITING  SYNDICATE. 

SECTION  PAGE 

147.  Informal  Agreements 269 

148.  A  Formal  Syndicate  Agreement 269 

149.  Characteristics  of  Syndicate  Agreements 277 

150.  Functions  of  Underwriting  Syndicates 278 

151.  Underwriting  Speculative  Securities 279 

152.  An  Example  of  Speculative  Underwriting       ....  280 


CHAPTER  XX. 
INVESTMENT  OF  CAPITAL  FUNDS. 

153.  Importance  of  Wise  Investment 284 

154.  The  Installment  Method  of  Getting  Cash  as  Needed       .  284 

155.  Disadvantages  of  this  Method 286 

156.  Other  Possible  Methods 287 

157.  How  Much  Shall  be  Invested  in  Fixed  Capital?    ...  288 

158.  Forms  of  Working  Capital 289 

159.  HowMuch  Working  Capital  Shall  be  Carried?     .      .      .  290 

160.  The  Practice  of  Large  Corporations 291 

161.  Factors  that  AiFect  Working  Capital 293 

162.  The  Working  Capital  of  the  Pennsylvania  Railroad  .      .  294 

163.  General  Conclusions  as  to  Working  Capital     ....  295 


CHAPTER  XXI. 
DISPOSITION  OF  GROSS  EARNINGS. 

164.  Determination  of  Income 297 

165.  Honesty  in  Stating  Gross  Earnings 298 

166.  What  Are  Operating  Expenses? 298 

167.  Necessity  for  Depreciation  Reserves 299 

168.  Income  From  Other  Sources  and  Deductions      .      .      .  302 

169.  HowMuch  Shall  be  Paid  Out  in  Dividends?  .      .      .      .303 

170.  Variability  of  Profits 304 

171.  Regularity  of  Dividends  Deeirable 308 

172.  Prudence  in  Paying  Dividends 309 


xiv  CONTENTS 

CHAPTER  XXII. 
BETTERMENT  EXPENSES. 

SECTION  PAGE 

173.  Two  Classes  of  Betterments .      .311 

174.  Sources  of  Funds  for  Betterments 312 

175.  Appropriations  from  Earnings 313 

176.  Objections  to  This  Method 314 

177.  The  Attitude  of  Stockholders 314 

178.  The  Case  of  the  Lehigh  Valley  Railroad 316 

179-     Policy  of  the  Union  Bag  and  Paper  Company     .      .      .  320 

180.  Borrowing  Funds  for  Betterments 321 

181.  Policy  of  the  Pennsylvania  Railroad 322 

182.  General  Conclusions  as  to  the  Financing  of  Betterments  323 


CHAPTER  XXIII 
CREATION  AND  USE  OF  A  SURPLUS. 

183.  Definition 325 

184.  Four  Sources  of  Surplus 326 

185.  The  Fifth  Source  —  Saving 327 

186.  Policy  of  the  "  Trusts '* 329 

187.  How  Should  Surplus  be  Invested 330 

188.  The  Surplus  as  a  "  Rainy  Day  Fund  " 330 

189.  Putting  the  Surplus  Back  Into  the  Property    ,..     .      .  333 


CHAPTER  XXIV. 
DISTRIBUTION  OF  THE  SURPLUS. 

190.  Effect  of  a  Surplus  on  Assets  and  Dividends     .      .      .335 

191.  Distribution  Through  Stock  Watering 337 

192.  Distribution  Through  Subscription  Privileges       .      .      .  339 

193.  An  Opportunity  Thus  Given  for  Cheap  Investment      .  340 

194.  Cashing  the  Privilege  —  The  Subsequent  Sale     .      .      .  841 

195.  "            "          "         —Short  Selling 342 

196.  "            "          "         —  Sale  of  Old  Stock     ....  343 

197.  "            "          "         —  Sale  of  "  Rights "  .      .      .      .  343 

198.  Theoretical  Value  of  a  Right 345 

199.  Privileged  Subscriptions  as  a  Method  of  Stock  Watering  347] 


CONTENTS  XV 

CHAPTER  XXV. 
MANIPULATION  BY  CORPORATION  OFFICERS. 

SECTION  PAGE 

200.  Ought  We  to  Study  Manipulation  ? 349 

201.  The  Corporate  Form  Favors  Manipulation     ....  349 

202.  Is  Manipulation  a  Necessary  Evil.^ 350 

203.  Scope  of  the  Chapters  on  Manipulation 351 

204.  Exorbitant  Salaries 352 

205.  Fraudulent  Contracts 353 

206.  New  Companies  for  Profitable  Business 355 

207.  Misuse  of  "  Inside  "  Information 358 

208.  Is  Manipulation  by  Officers  Common? 360 


CHAPTER  XXVI. 
MANIPULATION  BY  DIRECTORS. 

209-  Usual  Methods 361 

210.  Fraudulent  Contracts 362 

211.  Attitude  of  the  Courts 365 

212.  New  Companies  for  Profitable  Business 366 

213.  Juggling  Accounts 367 

214.  An  Accountant's  Observations 370 

215.  Remedies  for  This  Kind  of  Manipulation       ....    371 

216.  Inflicting  Loss  on  the  Corporation 373 

217.  The  Danger  in  Losing  Control  of  a  Corporation  .      .      .   375 


CHAPTER  XXVII. 
MANIPULATION  BY  AND  FOR  STOCKHOLDERS. 

218.  Cheating  Creditors 379 

219.  The  Chicago  and  Alton  Deal 380 

220.  Manipulation  Through  Subsidiary  Companies       .      .      .382 

221.  Central  of  Georgia  Income  Account 383 

222.  Squeezing  the  Minority  Stockholders 385 

223.  A  Complicated  Real  Estate  Proposition 387 

224.  Robbing  a  Partnership  to  Pay  a  Corporation      .      .       .389 

225.  Remedies  for  Manipulation 392 


xvi  CONTENTS 

CHAPTER  XXVIII. 
INSOLVENCY  AND  RECEIVERSHIPS. 

SECTION  PAGE 

226.  Two  Types  of  Insolvency 394 

227.  Causes  of  True  Insolvency ...  395 

228.  One  Cause  of  Legal  Insolvency  — "  Lack  of  Capital  "      .  S97i 

229.  The  Case  of  the  Detroit^  Toledo  &  Ironton  Railway  Com- 

pany       398 

230.  Additional  Causes  of  Legal  Insolvency 400 

231.  Two    Methods    of    Handling    Insolvency  —  Bankruptcy 

and  Dissolution 401 

232.  A  Third  Method  —  Appointment  of  a  Receiver  .      .      .  403 

233.  Duties  of  a  Receiver 404 

234.  Receiver's  Powers 406 


CHAPTER  XXIX. 
PRINCIPLES  OF  REORGANIZATION. 

235.  Reasons  for  Reorganization 408 

236.  The  Formation  of  Committees 410 

237.  Why  Not  Foreclose? 412 

238.  Problems  Confronting  the  Reorganization  Committee      .  413 

239.  Necessity  for  Cash 416 

240.  Raising  Cash  by  Assessments 417 

241.  Reducing  Fixed  Charges 420 

242.  Capitalization  of  the  Reorganized  Corporation     .      .      .  422 

243.  Summary  of  the  Chapter 424 


CHAPTER  XXX. 
THREE  TYPICAL  REORGANIZATIONS. 

244.  Growth  of  the  Santa  Fe  System 425 

245.  First  Reorganization  of  the  Santa  Fe  and  Its  Results      .  429 

246.  Second  Reorganization  and  Its  Results 431 

247.  Growth  of  the  Rock  Island  System 434 

248.  Rock  Island  Reorganization 437 

249.  Westinghouse  Reorganization 440 

Quiz  Questions 445 


INTRODUCTION 

Twenty  years  ago  a  knowledge  of  corporation  finance 
was  not  essential  to  the  average  business  man.  Only 
the  larger  concerns,  roughly  speaking,  were  organized 
in  the  corporate  form.  We  have  only  to  look  around 
us  to  see  that  the  situation  to-day  in  this  respect  is  en- 
tirely different.  The  corporate  form,  though  not  yet 
universal,  is  far  ahead  of  partnerships  and  of  individual 
proprietorships  in  popularity  and  in  influence  on  busi- 
ness methods.  As  its  advantages  become  better  known 
we  may  expect  to  see  it  adopted  even  by  small  and  back- 
ward concerns.  This  tendency  is  bringing  to  the  front 
numerous  problems  of  corporation  law  and  management 
with  which  every  man  in  business  should  be  familiar. 

From  this  point  of  view  the  present  volume  is  written. 
It  is  intended  primarily  for  the  information  and 
guidance  of  business  men  of  all  stations  and  degrees. 
Most  of  what  is  said  here  will  be  found  applicable  both 
to  large  and  to  small  corporations.  The  facts  and 
illustrations,  however,  are  largely  drawn  from  the 
experience  of  the  big  industrial  and  railroad  combina- 
tions. The  chief  reason  for  directing  attention  to  the 
big  corporations  is  that  their  methods  are  well  developed 
and  are  worthy  of  study  and  imitation  by  the  managers 
of  smaller  corporations.  Most  of  us  have  a  great  deal 
to  learn  from  the  men  who  control  the  financial  affairs 
of  such  companies  as  the  United  States  Steel  Corpora- 
tion, the  Union  Pacific  Railroad  Company,  and  the 
Pennsylvania  Railroad  Company,  to  mention  three  of 
our  greatest  and  best  managed  corporations. 


INTRODUCTION 

While  the  first  object  of  the  volume  is  to  serve  business 
men,  the  author  trusts  that  it  will  prove  useful  also  to 
at  least  four  other  groups : 

(a)  To  stock  and  bond  brokers  and  their  employes, 
many  of  whom,  the  writer  has  observed,  have  only  a 
fragmentary  knowledge  gained  from  experience,  not 
a  comprehensive  knowledge,  of  financial  operations. 

(b)  To  lawyers,  all  of  whom  should  have  a  clear 
understanding  of  the  financial  as  well  as  the  legal 
phases  of  corporate  organization  and  management. 

(c)  To  bankers,  who  are  constantly  dealing  with  all 
kinds  of  business  corporations. 

(d)  To  accountants,  to  whom  a  comprehension  of 
corporation  methods  and  problems  is  almost  as  essential 
as  a  knowledge  of  strictly  accounting  principles. 

This  list  might  be  indefinitely  extended.  It  is  not 
too  much  to  say  that  everyone  directly  or  indirectly 
connected  with  modern  business  ought  to  possess  for  his 
own  protection  and  advancement  a  correct  understand- 
ing of  the  principles  of  corporation  finance. 

The  thirty  chapters  in  the  volume  may  be  conveniently 
classified  into  seven  groups: 

Chapters  I-VI  present  the  elements  of  corporation 
law.  They  may  be  omitted  by  lawyers,  but  are  essential 
to  all  other  readers. 

Chapters  VII-XI  describe  all  the  methods  and  in- 
struments that  are  used  in  this  country  in  raising  funds 
for  corporations. 

Chapters  XII-XV  explain  how  corporations  are 
promoted,  and  give  in  illustration  a  brief  account  of  the 
United  States  Steel  Corporation. 

Chapters  XVI-XIX  discuss  the  four  methods  of 
selling  the  securities  of  a  corporation. 


INTRODUCTION 

Chapters  XX-XXIV  deal  with  the  problems  of 
honest  financial  management  of  a  corporation. 

Chapters  XXV-XXVH  discuss  the  schemes  and 
tricks  of  dishonest  manipulators. 

Chapters  XXVIII-XXX  are  concerned  with  the 
causes  of  insolvency  and  the  problems  of  reorganization. 

The  reader  should  bear  in  mind  that  all  these  questions 
are  treated  from  the  standpoint  of  corporation  officials, 
not  from  the  standpoint  of  stockholders  or  of  prospective 
investors.  Additional  light  may  be  obtained  from  the 
volume  on  Investment  and  Speculation^  in  which  the 
interests  of  buyers  of  securities  are  kept  to  the  front,  and 
from  the  volumes  on  Accounting  and  on  Commercial 

■^'^^'  W.  H.  Lough,  Je. 

New  York  University 
School  of  Commerce,  Accounts  and  Finance. 


CHAPTER  I 

THE  CORPORATE  FORM 

1.  "Non-stock"  corporations. — Everybody  knows  in 
a  vague  way  that  a  corporation  is  an  association  of  in- 
dividuals formed  to  carry  on  an  enterprise.  Compara- 
tively few  people,  however,  understand  just  what  the 
corporation  is  in  the  eyes  of  the  law  or  the  extent  and  the 
limitations  of  its  activities.  Obviously,  the  first  step  in 
the  study  of  corporation  finance  should  be  an  examina- 
tion of  the  powers  and  possibilities  of  this  peculiar  and 
wonderfully  effective  form  of  organization. 

Corporations  fall  into  two  distinct  groups.  There 
are,  first,  corporations  without  capital  stock,  or  "non- 
stock" corporations;  to  this  class  belong  almost  all 
churches,  hospitals,  chartered  clubs,  universities  and 
other  strictly  social  and  charitable  organizations.  The 
prime  characteristic  of  such  corporations  is  that  the 
members  share  equally  in  all  the  privileges  of  member- 
ship without  regard  to  the  amount  of  money  that  each 
may  have  contributed.  There  is  no  arrangement  for 
transacting  a  money-making  business  and  distributing 
profits  or  losses.  In  fact,  non-stock  corporations  exist 
either  for  the  common  benefit  of  all  the  members  or  for 
the  purpose  of  serving  the  public  at  large.  Many  in- 
teresting questions  as  to  the  rights  and  powers  of  such 
corporations  might  be  discussed;  but  the  discussion 
would  be  out  of  place  in  this  volume. 

2.  '^ Stock"  corporations, — We  are  here  concerned 
only  with  the  second  class,  namely,  "stock"  corporations; 

i-i  1 


^''"''    • 'COftPOfeATION  FINANCE 

Tto  this  class  belong  all  business  corporations.  Two  ap- 
parent exceptions,  mutual  insurance  societies  and  stock 
exchanges,  both  of  which  are  ordinarily  "non-stock" 
corporations,  may  be  noted;  both  organizations  in  their 
fundamental  character,  however,  are  simply  clubs  which, 
like  many  other  clubs,  offer  to  their  members  certain 
valuable  privileges.  "Stock"  corporations,  on  the  other 
hand,  are  formed  with  the  object  of  carrying  on  busi- 
ness ventures;  they  have  a  capital  stock  divided  into 
transferable  shares;  they  are  intended  to  make  profits 
which  are  to  be  distributed  to  their  members,  or  stock- 
holders, in  proportion  to  the  number  of  shares  each  one 
possesses;  each  stockholder  secures  his  shares  by  pur- 
chase for  valrable  consideration  from  the  corporation 
or  by  transfe.  from  some  previous  stocldiolder ;  each 
stockholder  is  c  owner  of  the  corporation  and  its  assets 
to  the  extent  of  the  number  of  shares  that  he  holds. 

3.  Definitions, — The  most  famous  definition  of  a 
corporation,  and  a  definition  that  in  its  main  features  is 
as  sound  to-day  as  it  ever  was,  is  that  given  in  the  Dart- 
mouth College  case  in  1819  by  Chief  Justice  Marshall 
of  the  United  States  Supreme  Court,  who  referred  to 
a  corporation  as  "an  artificial  being,  invisible,  intangible, 
and  existing  only  in  contemplation  of  law."  Blackstone, 
author  of  England's  greatest  legal  text-book,  gives  a 
definition  that  is  almost  as  well-known  as  Chief  Justice 
Marshall's  in  the  following  words:  "A  corporation  is 
an  artificial  person  created  for  preserving  in  perpetual 
succession  certain  rights,  which  being  conferred  on 
natural  persons  only,  would  fail  in  the  process  of  time." 
You  will  note  that  this  definition  emphasizes  the  most 
striking  distinctive  feature  of  the  corporation,  namely, 
its  artificial  personality.  The  corporation  is  an  entity 
or  being  in  itself,  apart  from  the  persons  who  organize 


THE  CORPORATE  FORM  S 

and  own  it.  Let  us  review  some  of  the  results  of  this 
legal  fiction  that  the  creation  of  a  corporation  brings 
into  the  world  a  new  person, — artificially  created,  to  be 
sure,  but  yet  endowed  with  many  of  the  powers  of  an 
ordinary  human  being. 

In  the  first  place,  as  the  corporation  has  an  existence 
apart  from  the  lives  of  any  or  all  its  owners,  it  is  not 
broken  up  by  the  death  or  withdrawal  of  any  owner. 
In  the  second  place,  the  corporation  has  the  right  to  buy 
and  sell  and  contract  debts  in  its  own  name  and  for  itself; 
it  may  even  owe  money  or  lend  money  to  some  or  all  of 
its  owners.  In  the  third  place,  it  may  sue  and  be  sued 
in  the  courts,  without  thereby  involving  any  of  its 
owners.  In  the  fourth  place,  it  may  enter  into  all 
kinds  of  legal  contracts,  just  as  an  individual  might 
do. 

4.  The  fiction  of  ^'corporate  entity" — Here,  then,  is 
the  first  and  most  fundamental  fact  about  the  corpora- 
tion for  the  student  to  grasp  and  keep  always  clearly  in 
view,  that  itils  a  separate,  distinct  artificial  person.  It 
is  true  that  within  the  last  few  years  the  courts  of  the 
United  States  have  shown  a  strong  tendency  to  go  be- 
hind this  artificial  personality  and  to  throw  responsibility 
on  the  owners  and  managers  of  a  corporation,  especially 
in  case  of  fraud.  Clark,  the  author  of  a  standard  legal 
work,  says: 

That  a  corporation  is  a  legal  entity,  separate  and  distinct 
from  the  members  who  compose  it,  is  a  mere  legal  fiction,  in- 
troduced for  the  convenience  of  the  corporation  in  transacting 
business,  and  of  those  who  do  business  with  it ;  and,  when  urged 
to  an  intent  and  purpose  not  within  its  reason  and  policy,  the 
fiction  will  be  disregarded,  and  the  fact  that  the  corporation  is 
really  a  collection  of  individuals  will  be  recognized,  even  at  law. 
Courts  of  equity,  in  every  instance,  look  behind  the  corporate 


4  CORPORATION  FINANCE 

entity  and  recognize  the  individual  members  and  will  do  so  when- 
ever justice  requires. 

Yet  the  fact  remains  that  the  corporation's  existence, 
property,  contracts  and  debts  all  adhere  to  the  corpora- 
tion itself  and  not  to  the  individuals  who  together  own 
the  corporation.  It  is  true,  also,  that  this  artificial  per- 
son, the  corporation,  has  neither  mind  nor  body  and  can- 
not therefore  think  or  act.  The  law,  however,  easily 
gets  over  this  difficulty  by  treating  the  managers  and 
officers  of  the  corporation  as  agents  empowered  to  carry 
on  its  operations.  \ 

5.  Corporations  in  ancient  nations, — This  fiction  of 
artificial  personality  seems  to  be  at  first  sight  an  un- 
necessary and  even  absurd  idea,  and  the  results  that  fol- 
low from  the  adoption  of  this  fiction  appear  more  like 
the  spinning  of  legal  cobwebs  than  the  working  out 
of  common-sense  principles.  But  a  little  further  study 
reveals  that  the  corporate  form  substantially  as  it  exists 
to-day  has  been  used  by  many  ancient  and  modern 
nations.  It  seems,  therefore,  that  there  must  be  some 
good  reason  or  reasons  for  its  widespread  use.  The 
archaeologists  tell  us  that  as  far  back  as  the  prosperous 
days  of  Babylon  the  inhabitants  of  that  ill-fated  country 
in  their  commercial  transactions  used  corporations  some- 
what as  we  use  them  now.  The  Romans  also  developed 
and  made  great  use  of  the  corporate  form  of  organizing 
enterprises.  Indeed,  it  is  asserted  by  Blackstone,  and 
was  at  one  time  universally  believed,  that  our  modern 
corporations  are  descendants  in  a  direct  line  of  the 
ancient  Roman  corporations.  Although  this  theory  is 
no  longer  fully  accepted,  it  remains  true  that  the  Roman 
law  with  regard  to  corporations  has  had  considerable 
influence  in  the  development  of  our  modern  corporation 
law.     Without  going  further  into  this  historical  survey. 


THE  CORPORATE  FORM  5 

which  is  a  little  outside  the  scope  of  this  book,  we  may 
lay  down  this  generalization,  that  in  almost  every  great 
active  commercial  nation  the  corporate  form  of  organ- 
ization has  sooner  or  later  come  into  existence.  It  must, 
then,  we  may  be  sure,  have  some  clear  and  important 
business  advantages. 

6.  Popularity  in  modern  times, — This  conclusion  is 
confirmed  when  we  reflect  that  along  with  the  marvelous 
business  development  of  the  last  century  there  has  been 
apparent  a  more  than  proportional  increase  in  the  num- 
ber and  importance  of  corporations.  At  first  only 
large  enterprises,  such  as  railroads,  steamship  companies 
and  great  manufacturing  establishments  were  so  organ- 
ized. Later  the  smaller  factories  and  wholesale  estab- 
lishments followed  the  lead  of  the  larger  concerns. 
Finally  within  the  last  few  years  we  have  witnessed 
both  in  Europe  and  particularly  in  this  country  the 
extension  of  the  movement  to  small  manufacturing  and 
retail  establishments.  The  drift  in  this  direction  is  so 
apparent  that  it  need  not  be  dwelt  upon  at  any  length. 
Every  reader  of  this  book  may  look  around  and  see  with- 
in his  own  circle  numerous  concerns  in  corporate  form 
which  were  conducted  a  few  years  ago  by  individuals 
or  partnerships.  Unless  this  tendency  receives  some 
unexpected  check  it  will  not  be  many  years  before  the 
corporate  form  will  be  adopted  by  almost  every  business, 
large  and  small,  in  the  United  States. 

7.  Adaptability  to  raising  large  amounts  of  capital, — 
Evidently  there  must  be  great  advantages  in  the  corpo- 
rate form;  otherwise  the  landslide  toward  it  would  long 
ago  have  been  stopped.  It  will  be  worth  while  to  review 
briefly  some  of  these  advantages. 

Originally,  as  has  been  said,  corporations  were  con- 
fined almost  altogether  to  large  enterprises  and  ^^re  used 


6  CORPORATION  FINANCE 

principally  because  of  the  facilities  which  they  afforded 
for  raising  and  handUng  large  amounts  of  capital.  In 
this  respect  they  are  obviously  far  superior  both  to  in- 
dividuals and  to  partnerships.  Not  even  the  richest 
individual — ^not  John  D.  Rockefeller  nor  Andrew  Car- 
negie nor  Lord  Rothschild — would  be  able  out  of  his  own  ^ 
resources  to  build  and  operate  one  of  the  great  railroad 
systems  of  the  United  States.  Even  if  one  of  these  men 
were  able  individually  to  take  care  of  an  enterprise 
of  this  size,  he  would  not  care  to  do  it.  Men  of  great 
wealth  do  not  consider  it  advisable  to  put  all  their  money 
into  one  business.  They  scatter  their  investments,  so 
that  if  one  proves  a  failure  profits  on  the  others  may 
more  than  counterbalance  the  loss. 

Nor  would  a  partnership,  great  and  wealthy  as  some 
partnerships  have  been,  be  an  efficient  method  of  bring- 
ing together  the  vast  amounts  of  capital  that  are  re- 
quired for  every  great  enterprise.  It  would  be  an 
extraordinary  coincidence  if  several  men  of  immense 
wealth,  who  might  conceivably  construct  and  own  in 
partnership  a  big  railroad  or  a  big  industrial  trust,  were 
able  to  harmonize  inevitable  differences  of  opinion  and 
to  co-operate  efficiently  in  a  partnership  arrangement. 
It  is  probably  safe  to  say  that  in  the  whole  commercial 
history  of  the  world  we  could  not  find  a  single  instance 
of,  say,  a  billion  or  even  half  a  billion — perhaps  even 
a  hundred  million — dollars  of  capital  raised  and  man- 
aged under  a  partnership  agreement.  It  is  well  to 
remember  in  this  connection  that  even  the  greatest  in- 
dividual fortunes  are  mere  dots  compared  to  the  total 
wealth  of  a  vast  country  like  the  United  States. 
Furthermore,  of  these  individual  fortunes  only  a  small 
part  ordinarily  is  free  at  any  one  time  to  be  used  or  in- 
vested as  the  owner  wills. 


THE  CORPORATE  FORM  7 

The  corporate  form,  on  the  other  hand,  has  infinite 
possibiKties  so  far  as  the  raising  and  managing  of  capi- 
tal is  concerned.  Any  number  of  people,  large  or 
small,  may  contribute  funds.  The  American  Tele- 
phone and  Telegraph  Company,  for  example,  has 
over  25,000  stockholders,  the  Pennsylvania  Railroad 
Company  nearly  59,000,  and  the  United  States  Steel 
Corporation  not  far  from  110,000.  A  large  num- 
ber of  owners  of  a  corporation  does  not  tend  to 
break  up  and  render  inefficient  the  management,  for 
the  control  of  whatever  capital  the  owners  contribute  is 
kept  in  the  hands  of  the  officers  of  the  corporation. 
Thus  the  corporation,  without  losing  in  efficiency,  may 
reach  out  into  the  highways  and  by-ways  of  the  land, 
draw  its  capital  from  a  thousand  or  from  a  hundred 
thousand  individuals  and  heap  up  vast  aggregations 
of  capital  that  could  not  possibly  be  obtained  in  any 
other  manner.  For  this  reason  it  is  inevitable  that  the 
corporate  form  should  be  used  in  the  financing  of! 
practically  every  large  enterprise. 

This  advantage  of  corporations,  that  they  are  able 
to  collect  and  to  make  use  of  the  small  contributions 
of  many  individuals,  though  most  prominent  in  great 
undertakings,  is  by  no  means  to  be  overlooked  in  the 
case  of  smaller  enterprises.  Frequently  an  inventor  or 
a  retail  dealer  or  any  small  business  man  who  needs  a 
few  hundred  or  a  few  thousand  dollars,  could  not  ob- 
tain it  from  his  own  immediate  relatives  and  friends. 
The  same  man,  perhaps,  may  easily  raise  the  capital  he 
requires  by  organizing  a  corporation  and  selling  small 
interests  to  a  considerable  number  of  people.  Many  a 
business  man  has  thus  obtained  necessary  capital  which 
he  has  made  the  foundation  of  a  fortune. 

8.  Permanence. — The   second   important  advantage 


8  CORPORATION  FINANCE 

of  the  corporate  form  is  permanence.  When  an  in- 
dividual owner  of  a  business  dies,  his  business  dies  with 
him.  It  may,  to  be  sure,  be  carried  on  by  his  family  or 
bought  by  strangers;  on  the  other  hand,  it  may  be  that 
no  practicable  method  of  disposing  of  it  except  at  an 
enormous  sacrifice  will  be  found.  This  is  largely  a 
matter  of  chance,  because  no  organization  for  carrying 
on  the  business  is  in  existence.  A  partnership  is  almost 
equally  subject  to  chance.  When  a  partner  dies,  the 
firm  is  thereby  automatically  dissolved.  The  surviving 
partner  or  partners  may,  of  course,  form  a  new  firm  and 
take  over  the  interest  of  the  deceased  partner.  In  so 
doing,  however,  disputes  are  liable  to  occur,  especially 
in  those  lines  of  business  where  the  earnings  are  irreg- 
ular and  the  value  of  the  assets  is  not  clearly  defined. 
If  the  surviving  partners  are  unable  to  continue  the 
business  properly  or  are  disposed  to  drive  a  hard  bargain, 
the  estate  of  the  deceased  partner  may  be  deprived  of 
a  large  part  of  its  rightful  interest  in  the  business. 
Here,  again,  there  is  no  permanent  machinery  for 
managing  the  business.  The  partnership,  like  the  in- 
dividual business,  is  subject  to  all  the  uncertainties  and 
calamities  that  beset  the  lives  of  individual  human  beings. 
The  corporation,  on  the  other  hand,  exists  until  it 
becomes  bankrupt,  is  allowed  to  lapse  or  is  voluntarily 
dissolved.  The  death  of  any  man,  even  if  he  owns  99 
per  cent,  of  the  stock  of  the  corporation,  does  not  affect 
the  corporation  itself.  It  is  an  "artificial  being,"  a 
creature  of  the  law  not  subject  to  the  infirmities  of 
human  existence.  It  is  so  organized  that  if  one  officer 
dies  or  withdraws,  a  successor  may  be  quickly  chosen. 
As  the  corporation  exists  apart  from  the  persons  who 
own  it  and  as  control  is  vested  in  its  officers,  the  death 
or  withdrawal  of  an  owner  does  not  at  all  disturb  its 


THE  CORPORATE  FORM  9 

machinery,  and  the  death  or  withdrawal  of  an  officer 
means  simply  that  someone  else  must  be  found  and  ap- 
pointed to  the  position. 

9.  Centralization  of  control, — This  brings  us  to  the 
third  important  advantage  of  the  corporate  form, 
namely,  its  centralization  of  power  and  responsibility. 
In  this  particular  feature  it  cannot  be,  of  course,  supe- 
rior to  individual  ownership,  but  it  is  far  ahead  of  the 
partnership.  As  the  law  does  not  recognize  in  the  part- 
nership anything  but  a  group  or  association  of  individ- 
uals, it  follows  that  each  partner  is  empowered  to  conduct 
the  business,  to  buy  and  sell  the  partnership  assets,  to 
make  binding  contracts  and  incur  debts.  Ordinarily, 
to  be  sure,  the  partners  mutually  agree  to  a  fixed  division 
of  duties  and  powers,  but  this  division  is  not  supposed 
to  be  known  or  to  be  binding  on  outsiders.  Each 
partner,  so  far  as  his  dealings  with  outsiders  are  con- 
cerned, is  the  whole  partnership.  Obviously,  therefore, 
no  partnership  should  ever  be  formed  except  between 
persons  who  have  entire  confidence  in  each  other;  and 
even  then  a  partnership  often  proves  an  unsafe  and 
inefficient  method  of  conducting  business.  Except  by 
mutual  agreement  binding  only  on  themselves,  to  repeat, 
there  is  no  clear-cut  division  of  powers  and  responsi- 
bilities. 

Under  the  corporate  form,  on  the  other  hand,  busi- 
ness can  be  transacted  only  by  the  duly  appointed 
officers;  no  owner,  unless  he  is  also  an  officer — even 
though  he  hold  almost  all  the  stock — ^has  any  authority 
to  transact  business  for  the  corporation.  Each  of  the 
officers  of  the  corporation,  as  is  explained  in  the  chapter 
on  "Interior  Organization,"  has  his  sphere  of  duties  care- 
fully defined,  both  within  the  corporation  and  outside. 
Persons  not  connected  with  the  corporation  are  expected 


10  CORPORATION  FINANCE 

to  have  their  dealings  only  with  the  duly  authorized 
officers,  and  if  they  do  not  exercise  reasonable  care  in 
this  respect  may  find  whatever  agreements  or  contracts 
they  make  invalid.  This  will  be  more  clearly  understood 
by  the  reader  after  a  study  of  the  chapters  on  agency 
in  the  volume  on  Commercial.  Law.  Furthermore, 
the  relations  of  the  corporate  officers  to  each  other  are 
clearly  defined  and  the  gradations  of  authority  are  so 
marked  that  each  one  may  understand  clearly  just  how 
far  he  is  empowered  to  act  on  his  own  judgment  and 
what  questions  he  should  refer  to  his  official  superiors. 
The  great  advantage  of  this  care  in  organization  and 
in  delegation  of  power  is  so  obvious  that  it  need  not  be 
dwelt  upon  at  any  length.  A  well-managed  corporation 
carries  on  its  affairs  with  the.  precision  and  smoothness 
of  a  well-disciplined  army. 

10.  Transferability  of  ownership, — ^A  fourth  advan- 
tage of  the  corporate  form  is  the  ease  with  which  its 
ownership  may  be  transferred.  An  individual  owner 
who  desires  to  sell  his  property  must  find  a  purchaser  for 
all  of  it  at  one  and  the  same  time.  A  partner  who  de- 
sires to  sell  his  interest  in  the  firm  must  either  make  some 
satisfactory  arrangement  with  the  other  partners,  which 
may  be  a  difficult  matter,  or  must  find  a  purchaser  who 
offers  satisfactory  terms  and  is  personally  acceptable  to 
the  other  partners,  and  that  is  likely  to  prove  still  more 
difficult.  Altogether  the  problem  of  withdrawing  funds 
that  have  been  invested  in  an  individually-owned  prop- 
erty or  in  a  partnership  is  almost  always  hard  and 
frequently  insoluble.  Under  the  corporate  form  the 
problem  is  much  simpler.  The  ownership  of  a  corpo- 
ration is  represented  by  shares,  any  or  all  of  which  may  be 
transferred  from  hand  to  hand  without  interfering  in 
the  least  with  the  stability  of  the  corporation.    An  owner 


THE  CORPORATE  FORM  11 

of  several  shares  need  not,  therefore,  find  any  one  person 
to  take  all  his  property  off  his  hands ;  he  may  sell  a  few 
shares  to  one  man,  one  or  two  to  another,  and  so  on,  and 
thus  dispose  of  his  property  piecemeal.  Furthermore, 
as  the  corporation  is  managed  directly  by  the  officers,  not 
by  the  owners,  no  consideration  ordinarily  need  be  given 
to  the  question  as  to  whether  or  not  a  prospective  buyer 
is  a  good  business  man  or  is  acceptable  to  the  other 
persons  interested  in  the  corporation.  Women,  old  men, 
administrators  and  trustees  of  estates,  institutions  of  all 
kinds — all  are  possible  purchasers  of  corporate  securities. 
Thus  the  owner  of  corporate  shares  finds  his  market 
much  broader  and  his  facilities  for  selling  much  better 
than  does  the  owner  of  a  partnership  interest.  The  se- 
curities of  large  corporations  are  constantly  dealt  in  on 
the  stock  exchanges  of  large  cities,  and  thus  a  continuous 
and  easily  accessible  market  is  afforded  to  every  owner. 
11.  Limited  liability, — The  fifth  and  last  important 
advantage  of  the  corporate  form  is  the  fact  that  the 
liability  and  possible  loss  of  each  owner  is  limited.  Gen- 
erally speaking,  the  owner  of  any  corporation  security 
is  safe  in  reflecting  that  though  the  security  may  become 
worthless  and  he  may  lose  all  that  he  paid  for  it,  he 
cannot  possibly  lose  more  than  that  amount.  The  reader 
may  perhaps  think  that  to  the  owner  of  the  stock  of  a 
failed  corporation  this  statement  affords  but  cold  com- 
fort; but  compare  his  situation  with  that  of  a  partner  in 
a  bankrupt  firm.  The  partner  may  not  only  lose  all 
that  he  invested  in  the  firm,  but  in  addition  is  personally 
liable  for  all  the  unpaid  debts  of  the  firm.  As  has  been 
explained  above^  it  is  possible  that  these  debts  may  have 
been  foolishly  or  even  fraudulently  contracted  by  some 
other  partner;  yet  that  fact  would  not  relieve  any  other 
partner  from  his  personal  liability.     No  doubt* most 


la  CORPORATION  FINANCE 

readers  of  this  paragraph  will  call  to  mind  instances  in 
their  own  experience  of  individual  owners  or  of  partners 
in  disastrous  enterprises  who  have  lost  everything  they 
owned,  including  even  their  homes  and  most  of  their 
personal  property,  by  the  failure  of  such  enterprises. 
If  a  corporation  fails,  on  the  other  hand,  and  its  debts 
prove  greater  than  its  assets,  the  creditors  have  no  claim 
on  the  property  of  the  stockliolders  outside  the  failed 
business. 

An  important  exception  to  this  principle  of  limited 
liability  exists  in  the  case  of  stockholders  of  national 
banks.  They  are  individually  liable  in  case  of  failure 
not  only  for  their  investment  but  for  an  additional  sum 
equal  to  the  -psiT  value  of  their  holdings  of  bank  stock. 
A  similar  rule  applies  in  California  to  stockholders  of 
corporations  of  all  kinds  and  there  are  one  or  two  other 
exceptions  which  are  referred  to  in  Chapter  IV.  Even 
in  such  cases,  however,  though  the  liability  of  stock- 
holders is  somewhat  greater  than  with  the  ordinary  cor- 
poration, it  is  still  strictly  limited. 

No  doubt  this  principle  of  limited  liability  has  been 
one  of  the  main  advantages  of  corporations  that  has  led 
to  their  formation  in  a  great  many  cases,  and  especially 
has  encouraged  in  recent  years  the  widespread  move- 
ment to  change  partnerships  into  corporations.  No 
business  man,  especially  one  who  has  considerable  per- 
sonal property  and  perhaps  is  advanced  in  years,  likes  to 
reflect  that  at  any  moment,  through  the  fraud  or  mis- 
management of  some  subordinate  or  partner,  or  through 
some  unavoidable  natural  calamity,  he  may  be  compelled 
to  give  up  his  home  and  personal  property  in  order  to 
satisfy  the  demands  of  business  creditors.  The  corpo- 
rate form  of  business  relieves  him  of  this  haunting 
spectre. 


THE  CORPORATE  FORM  13 

The  prominent  advantages  of  the  corporate  form, 
which  have  brought  about  its  great  extension  in  recent 
years,  may  then  be  summed  up  as  follows: 

r(  1 )  Flexibility.  The  owners  of  a  corporation  may 
be  few  or  numerous.  This  makes  the  corporate  form 
especially  well  adapted  to  collecting  large  amounts  of 
capital  by  means  of  small  contributions  from  a  great 
many  people. 

(2)  Permanence.  The  life  of  a  corporation  is  not 
dependent  on  the  life  or  on  the  caprice  of  any  individual. 

(3)  Centralization  of  control.  Under  the  cor- 
porate form  the  officers  of  the  corporation  within  care- 
fully defined  limits  exercise  complete  control. 

(4)  Transferability  of  ownership.  Corporate 
shares  may  be  readily  sold  either  in  a  block  or  piecemeal 
and  have  a  wide  market. 

(5)  Limited  liability.  The  corporation  alone, 
with  certain  minor  exceptions,  is  liable  for  its  own  debts 
and  the  shareholders  cannot  lose  more  than  their  orig- 
inal investments^ 

12.  Disadvantages  of  the  corporate  form, — In  view  of 
these  advantages  it  maj^  be  asked  why  all  kinds  of  busi- 
ness without  exception  are  not  organized  under  the  cor- 
porate form.  The  answer  is  that  certain  minor  disad- 
vantages, which  in  some  instances  are  sufficient  to  offset 
the  advantages  named,  are  inseparable  from  corpora- 
tions. These  disadvantages  may  be  briefly  summed  up 
as  follows: 

\(1)  Increased  expense.  All  states  impose  certain 
incorporation  fees  and  annual  franchise  taxes  on  corpo- 
rations, which  taxes  are  in  addition  to  the  ordinary  state 
and  local  taxes  on  property.  These  taxes  are,  however, 
uniformly  small,  as  the  reader  may  see  by  turning  to  the 
table  of  fees  and  taxes  in  Chapter  IV.     In  addition. 


\ 


14  CORPORATION  FINANCE 

legal  assistance  is  almost  always  necessary  in  forming 
corporations,  and  there  may  be  an  additional  charge  on 
this  account  of  from  $25  up.  These  corporate  expenses 
are,  of  course,  too  slight  to  be  worth  much  consideration, 
except  in  the  case  of  very  small  enterprises,  where  they 
may  sometimes  be  of  sufRcient  importance  to  prevent 
the  adoption  of  the  corporate  form. 

(2)  Limited  POWERS.  As  the  corporation  derives  all 
its  powers  from  the  state  in  which  it  is  incorporated,  and 
as  all  its  powers  should  be  distinctly  stated  in  its  articles 
of  incorporation  (see  Chapter  II),  it  may  be  somewhat 
hampered  at  times  by  lack  of  authority  to  carry  on  oper- 
ations that  would  be  profitable.  This,  however,  is  a 
superficial  objection  that  may  be  readily  dismissed;  for 
a  good  corporation  lawyer  will  always  find  it  possible  to 
include  in  the  statement  of  the  powers  of  the  corporation 
authority  for  every  act  that  would  be  necessary  in  prac- 
tice. If  not,  it  is  always  easy  to  form  a  new  corporation 
for  whatever  specific  action  is  desired,  j  This  point  also 
is  further  discussed  in  Chapter  II. 

f(S)  Limited  credit.  A  lender  of  money  would,  of 
course,  prefer,  other  things  being  equal,  to  lend  to  an 
individual  or  a  partnership,  rather  than  to  a  corporation, 
because  the  liability  of  the  owners  of  the  property  in  the 
former  case  is  unlimited,  and  in  the  latter  case,  as  has 
been  explained,  is  limited.  Thus  a  partnership  which 
is  converted  into  a  corporation  will  sometimes  be  em- 
barrassed more  or  less  by  reluctance  of  its  creditors  to 
continue  extending  credit  as  freely  as  before  the  con- 
version. This  objection,  which  is  of  importance  usually 
only  in  the  case  of  a  small  and  closely  held  business,  may 
be  overcome,  if  desired,  by  the  officers  or  certain  stock- 
holders personally  endorsing  the  corporation's  notes  and 
bills  payable.     By  so  doing  they,  of  course,  lose  the 


THE  CORPORATE  FORM  15 

advantage  of  limited  liability,  but  they  retain  all  the 
other  advantages  of  the  corporate  form.  There  are 
some  business  activities,  however,  in  which  the  personal 
element  is  so  prominent  as  to  make  unhmited  liability 
desirable.  A  firm  of  accountants,  for  instance,  could 
not  be  changed  to  a  corporation  without  forfeiting  to 
some  extent  the  confidence  of  the  business  public,  for 
every  public  accountant  is  and  ought  to  be  personally 
liable  to  the  fullest  extent  for  the  honesty  and  accuracy 
of  his  work.  The  same  thing  may  be  said  of  bankers 
and  engineers,  and  to  some  extent  of  business  advisers 
and  systematizers ;  for  such  activities  the  corporate  form, 
on  account  of  its  limited  liability  feature,  is  ill-adapted. 

(4)  Governmental  control.  Some  concerns  are 
strongly  averse,  for  good  reasons,  to  any  publicity  what- 
ever as  to  their  operations  and  financial  results.  They 
may  perhaps  be  making  so  much  money  that  they  desire 
to  keep  it  secret  in  order  to  avoid  attracting  competitors ; 
or  their  real  business  may  be  quite  different  from  their 
ostensible  business,  and  they  would  not  desire  to  attract 
attention  to  this  fact  by  the  inclusion  of  unusual  powers 
in  articles  of  incorporation.  For  fear  of  governmental 
supervision,  therefore,  they  retain  the  partnership,  even 
with  all  its  disadvantages. 

The  reader  will  readily  see  that  this  list  of  disadvan- 
tages of  the  corporate  form  does  not  include  anything 
of  great  importance  to  most  legitimate  kinds  of  business. 
Certainly  the  disadvantages  are  of  little  weight  in  most 
cases  in  comparison  with  the  obvious  and  substantial 
gains  that  may  be  had  by  adopting  the  corporate  form. 
We  are  justified  in  concluding,  therefore,  that  the 
tendency  toward  the  corporate  form  of  conducting  busi- 
ness, which  has  been  referred  to  above,  will  not  dimin- 
ish, but  rather  will  increase  in  the  coming  years.     The 


16  CORPORATION  FINANCE 

corporation  is  the  efficient  twentieth  centuiy  means  of 
conducting  business.  In  city  and  in  country,  from  the 
captains  of  finance  to  the  smallest  units  in  the  army  of 
business,  in  transportation,  in  manufacturing,  in  trad- 
ing, even  in  farming,  the  corporation  has  come  to  be 
recognized  as  the  best  form  yet  discovered  for  organizing 
the  production  of  wealth. 

To  confess  oneself  ignorant  of  the  nature,  the  func- 
tions, the  abuses  and  the  possibilities  of  this  mighty  in- 
strument is  indeed  a  confession  of  business  inefficiency 
and  narrowness.  The  pages  that  follow  are  to  be  de- 
voted to  a  discussion  of  the  formation  and  management 
of  corporations  which,  it  is  hoped,  will  place  this  truly 
important  and  somewhat  difficult  subject  in  a  clear  light 
before  our  readers. 


CHAPTER  II 

LEGAL  STATUS  OF  THE  CORPORATION 

13.  Defining  and  controlling  instruments, — The  cor- 
poration, we  have  said,  is  a  "creature  of  the  law,"  and  this 
statement  is  to  be  taken  hterally.  This  artificial  creature 
has  no  existence,  no  powers,  no  privileges,  no  duties,  ex- 
cept those  which  are  conferred  upon  it  either  by  express 
statement  or  by  implication.  The  artificial  creature,  in 
other  words,  does  not  have  what  we  may  call  the  natural 
rights  of  an  individual  to  live  unmolested  and  to  pursue 
whatever  objects  he  pleases,  so  long  as  the  rights  of  oth- 
ers are  not  interfered  with,  but  only  artificial  rights.  In 
order  to  determine  in  any  particular  case,  therefore,  what 
a  corporation  may  or  may  not  do  and  what  its  standing 
is,  we  must  look  to  the  particular  instruments  which 
give  it  being  and  control  its  actions.  These  instruments 
in  every  state  in  the  Union  are  three  in  number: 

(1)  The  Constitution  of  the  State. 

(2)  The  General  Corporation  Act. 

(3)  The  Charter  of  each  particular  corporation. 
Supplementing  the  charter,  practically  all  corporations 
have  a  set  of  by-laws  for  their  own  guidance.     In  order 
to  understand  the  legal  status  of  a  corporation  we  must 
consider  briefly  each  of  these  instruments. 

14.  Common  law  of  corporations, — It  must  be  borne 
in  mind,  in  connection  with  what  follows  in  this  chapter, 
that  corporations  of  one  kind  or  another  have  been  in 
existence  for  a  very  long  time,  and  that  the  courts  of 
England  and  of  the  United  States  have  given  a  large 
1-2  17 


18  CORPORATION  FINANCE 

number  of  decisions  dealing  with  the  duties  and  powers 
of  corporations.  These  decisions  form  the  great  body  of 
common  law  with  reference  to  corporations;  and  this 
common  law,  for  which  search  must  be  made  through  the 
precedents  of  many  years,  governs  where  it  is  not  super- 
seded. Corporations  as  forms  of  business  organization, 
however — and  especially  as  forms  of  organization  for 
relatively  small  enterprises — are  comparatively  modern. 
From  the  very  beginning  the  English  Parliament  and 
the  state  legislatures  of  this  country  have  found  it  ex- 
pedient to  enact  statutes  in  order  to  define  clearly  the 
powers  and  duties  of  corporations.  These  statutes  in 
every  state  are  now  so  explicit  and  comprehensive  as  to 
govern  the  great  mass  of  corporate  activities.  They 
form  the  body  of  statutory  law  with  reference  to  corpo- 
rations. The  reader  will  find  in  the  volume  on  Com- 
mercial Law  a  full  exposition  of  the  relations  between 
common  and  statutory  law  and  of  the  manner  in  which 
statutes  of  the  legislature  are  interpreted  by  the  courts. 
For  our  purpose  it  is  enough  to  say  that  the  statute  law 
supersedes  the  common  law  wherever  the  two  disagree 
and  that  statute  law  with  regard  to  corporations  is  so 
voluminous  that  we  need  rarely  go  back  of  it  to  the 
common  law. 

15.  The  state  constitution. — The  fundamental  law  in 
each  state  of  the  Union  is  the  constitution  of  the  state, 
and  no  provision  which  conflicts  with  any  clause  in  the 
state  constitution  will  be  legal.  This  is  a  point,  not 
merely  of  theoretical,  but  also  at  times  of  distinct  practi- 
cal importance.  For  instance,  the  Constitution  of  the 
State  of  Pennsylvania  prescribes  that  all  Pennsylvania 
corporations  shall  elect  their  offieers  by  what  is  known 
as  "cumulative  voting" — a  method  that  is  described  at 
some  length  in  Chapter  VI.     In  one  case,  with  which 


LEGAL  STATUS  OF  THE  CORPORATION         19 

the  writer  happens  to  be  familiar,  certain  stockholders 
of  a  small  Pennsylvania  corporation  planned  to  pass  a 
rule  against  cumulative  voting  and  by  means  of  that  rule 
to  elect  all  members  of  the  board  of  directors.  Great 
was  their  chagrin  and  surprise  when  they  discovered  that 
no  Pennsylvania  corporation  is  competent  to  enforce 
such  a  rule  as  they  proposed.  It  frequently  happens 
that  some  of  the  ordinary  statute  provisions  of  a  state 
are  found,  when  tested  in  the  courts,  to  be  in  conflict 
with  some  provision  of  the  state  constitution  and  there- 
fore null  and  void.  The  reader,  then,  should  not  forget 
that  behind  every  enactment  of  the  legislature  looms  the 
constitution  of  the  state,  a  fundamental  factor  that 
should  not  be  left  out  of  his  reckoning. 

16.  Method  of  creating  the  corporation.— -ThQ  direct 
legislative  authority  to  create  a  corporation  may  be  given 
in  one  of  two  ways,  by  special  enactment  of  the  legisla-r''^ 
ture  for  the  benefit  of  this  particular  corporation,  or  by 
a  general  act  which  governs  the  creation  of  all  corpora- 
tions. Formerly  the  first  named  method  was  universal. 
It  proved  itself,  however,  both  inconvenient  and  unfair. 
Authority  to  incorporate  was  granted  arbitrarily  by  the 
legislature  for  certain  enterprises  and  denied  to  others 
equally  deserving.  It  was  necessary  to  have  a  "pull" 
in  order  to  get  the  desired  enactment.  Favoritism  and 
corruption,  coupled  with  unwise  conservatism,  were  the 
natural  results  of  this  method.  It  has  therefore  fallen 
into  disuse  and  is  definitely  prohibited  by  the  constitu- 
tions of  many  states  of  the  Union.  One  rather  conspic- 
uous exception  to  the  general  rule  that  corporations  are 
no  longer  formed  and  managed  under  the  provision  of 
special  enactments  is  the  Bay  State  Gas  Company,  a 
corporation  organized  by  Mr.  J.  Edward  Addicks,  and 
now  controlled,  it  is  understood,  by  Mr.  Thon^as  W, 


20  CORPORATION  FINANCE 

Lawson.  This  company  was  given  large  powers  and 
privileges  by  a  special  act  of  the  Legislature  of  Dela- 
ware during  the  time  when  Mr.  Addicks  was  reputed 
to  be  the  political  boss  of  the  State. 
.  The  present-day  method  of  creating  the  corporation 
is  by  compljang  with  the  provisions  of  a  general  corpo- 
ration act — ^in  some  states  called  an  "enabling  act." 
Such  an  act  usually  prescribes  the  general  purposes  for 
which  corporations  may  be  lawfully  formed,  the  chief 
powers  which  they  may  possess — such  as  power  to  hold 
property  in  the  parent  and  in  other  states,  power  to  hold 
its  own  stock,  power  to  hold  stock  of  other  corporations 
(not  conferred  by  all  states),  power  to  borrow  money, 
power  to  do  business  in  other  states,  and  so  on — the  num- 
ber of  incorporators  and  stockholders,  the  manner  and 
lawful  purposes  of  issue  of  capital  stock,  the  rights  of  the^ 
stockholders,  the  minimum  numbers  of  directors  and  of 
officers,  the  character  and  amount  of  taxes,  the  nature  of 
reports  required,  the  exact  form  to  be  followed  in  incor- 
porating, and  so  on.  Under  such  a  general  act  any 
citizens  of  the  state — sometimes  of  other  states — 
who  meet  the  requirements  of  the  law  may  form  a 
corporation.  Thus  the  favoritism  and  corruption  in- 
cident to  the  old  method  of  special  enactment*  are 
eliminated.  The  universal  establishment  of  these 
general  corporation  acts  is  one  of  the  most  important 
reforms  in  business  methods  of  the  second  half  of  the 
nineteenth  century.  Though  many  of  these  acts — as 
is  pointed  out  in  Chapter  IV — are  far  from  perfect,  we 
all  have  reason  to  be  profoundly  thankful  that  they  exist 
at  all. 

17.  Essential  features  of  the  charter. — We  come  now 
to   the    immediate    instrument    of    incorporation,    the 


LEGAL  STATUS  OF  THE  CORPORATION    21 

charter — sometimes  called  the  certificate  of  incorpora- 
tion or  the  articles  of  incorporation.  Where  the  charter 
is  obtained  under  a  general  corporation  act,  it  is  drawn 
by  the  incorporators  or  their  attorney  and  presented  to 
the  proper  state  official,  usually  the  secretary  of  state. 
If  the  charter  as  drawn  is  approved,  the  secretary  of 
state  signifies  his  acceptance  thereof,  and  the  corporation 
comes  into  being.  There  is  no  favoritism  in  this  pro- 
cedure, as  there  is  in  the  granting  of  charters  by  special 
acts;  the  secretary  of  state  has  no  authority  to  refuse 
any  charter  which  is  properly  drawn  and  which  complies 
with  the  provisions  of  the  state  law. 

A  charter  need  not  be  a  very  lengthy  instrument,  al- 
though large  companies  sometimes  find  it  desirable  to 
prevent  future  misunderstanding  by  inserting  into  the 
'charter  a  great  many  details  not  absolutely  essential. 
In  practically  all  states  every  charter  must  contain, 
among  other  things,  the  following  information: 

(1)  The  name  of  the  corporation. 

(2)  The  purpose  or  purposes  for  which  it  is  formed. 

(3)  The  amount  of  capital  stock,  and  if  there  is  a 
division  into  classes  of  stock,  the  rights  of  each  class. 

(4)  The  number  of  shares  of  stock. 

(5)  The  location  of  the  principal  business  office. 

(6)  The  period  of  existence  of  the  corporation,  which 
is  usually  unlimited  or  perpetual. 

(7)  The  names  and  usually  the  post-office  addresses 
of  the  incorporators. 

If  the  reader  desires  a  more  detailed  statement  of  the 
requirements  in  any  particular  state,  he  cannot  do  better 
than  to  go  direct  to  the  statutes  of  that  state.  It  would 
lead  us  too  far  afield  if  we  were  to  enter  here  on  any 
comprehensive  legal  study  of  charter  forms  and  provi- 


^2  CORPORATION  FINANCE 

sions.  A  few  remarks,  however,  as  to  the  essential  fea- 
tures of  a  charter  and  the  presentation  of  the  sample 
form  following  will  not  be  out  of  place  and  will  help  to 
make  clear  some  points  of  corporation  practice  that 
might  otherwise  be  obscure. 

18.  ^  sample  charter. — The  following  is  a  very  brief 
and  simple  charter,  which  conforms  to  the  laws  of  the 
State  of  New  Jersey.  The  form  in  other  states  would 
be  slightly  different.  The  writer  is  indebted  to  Mr. 
Thomas  Conyngton  for  permission  to  copy  this  form 
from  his  manual  "The  Modern  Corporation." 

CERTIFICATE  OF  INCORPORATION 

OF  THE 

CARHART  DRUG  COMPANY. 

We,  the  undersigned,  for  the  purpose  of  forming  a  corpora* 
tion  under  and  by  virtue  of  the  provisions  of  an  act  of  the 
Legislature  of  the  State  of  New  Jersey,  entitled  "  An  Act  con- 
cerning corporations  (Revision  of  1896),"  and  the  several  sup- 
plements thereto  and  acts  amendatory  thereof,  do  hereby  sever- 
ally subscribe  for  and  agree  to  take  the  number  of  shares  of 
stock  of  the  said  corporation  hereinafter  placed  opposite  our 
respective  names,  do  further  certify  and  set  forth  as  follows: 

First — The  name  of  said  corporation  shall  be 

"CARHART  DRUG  COMPANY." 

Second^ — The  location  of  its  principal  office  in  the  State 
of  New  Jersey  shall  be  at  No.  15  Exchange  Place,  Jersey  City. 

The  name  of  the  agent  who  shall  be  therein  and  in  charge 
thereof,  upon  whom  process  against  this  Corporation  may  be 
served,  is  the  Corporation  Trust  Company  of  New  Jersey. 

Third — The  objects  for  which  this  corporation  is  formed 
are: 

(a)  To  manufacture,  prepare,  compound,  mix,  com- 

bine, buy,  sell  and  generally  deal  in  all  manner  of 


LEGAL  STATUS  OF  THE  CORPORATION    23 

chemicals,  chemical  products,  drugs  and  pharmaceu- 
tical compounds  and  preparations,  and  to  patent, 
register  or  otherwise  protect  the  same.^ 

(b)  To  obtain,  purchase  or  otherwise  acquire  formulae, 
patents  and  secret  processes  for  the  manufacture  and 
preparation  of  chemicals,  drugs  and  the  compounds 
and  preparations  thereof,  and  to  operate  under,  sell, 
assign,  grant  licenses  in  respect  of,  or  otherwise  turn 
the  same  to  account. 

(c)  To  enter  into,  carry  out  or  otherwise  turn  to  ac- 
count contracts  of  every  kind;  to  have  and  maintain 
offices  within  and  without  the  State ;  to  acquire,  hold, 
mortgage,  lease  and  convey  or  otherwise  use  or  dis- 
pose of  real  and  personal  property  in  any  part  of  the 
world ;  and  in  general  to  carry  on  such  operations  and 
enterprises  and  to  do  all  such  things  in  connection 
therewith  as  may  be  permitted  by  the  laws  of  New 
Jersey  and  be  necessary  or  convenient  in  the  conduct 
of  the  Company's  business. 

Fourth — The  total  authorized  stock  of  the  corporation  shall 
be  twenty -five  thousand  dollars  ($25,000),  divided  into  two  hun- 
dred  and  fifty  (250)  shares  of  the  par  value  of  one  hundred 
dollars  ($100)  each,  and  the  amount  of  capital  stock  with  which 
said  corporation  will  begin  business  is  five  thousand  dollars 
($5,000). 

Fifth — The  names  and  post-office  addresses  of  the  incor- 
porators and  the  number  of  shares  subscribed  for  by  each  are 
as  follows: 

Names  Addresses  Shares 

Willis  J.  Carhart.  .  .15  Exchange  Place,  Jersey  City,  N.  J.  40 
Sheldon  McCammis.    "  "  "  "  "       "    "      5 

John  B.  Whelan  ..."  "  "  "         "       "    "      5 

Sixth — The  period  of  existence  of  said  corporation  shall  be 
unlimited. 

In  Witness  Whereof,  we  have  hereunto  set  our  h^nds  and 


24  CORPORATION  FINANCE 

seals  this  21st  day  of  July,  A.  D.  nineteen  hundred  and 
eight. 

Willis  J.  Carhart.      (L.  S.) 
Sheldon  McCammis.    (L.  S.) 
John  B.  Whelan.        (L.  S.) 
In  the  presence  of 
Harmon  Watson. 
Thomas  O'Connell. 

(Execution  in  due  form.) 

19.  The  corporate  name, — The  name  of  a  corporation 
is  part  of  its  property  and  sometimes — especially  after 
the  corporation  has  been  long  enough  established  to  have 
acquired  good  will — is  highly  valuable  property.  For 
that  reason,  a  new  corporation  is  not  allowed  to  assume 
a  name  already  taken  by  a  previously  existing  corpora- 
tion nor  even  a  name  so  similar  as  to  cause  confusion. 
If  the  older  corporation,  however,  in  such  a  case  were 
not  incorporated  or  licensed  in  the  same  state  as  the  new 
company,  the  state  authorities  would  have  no  right  to 
reject  the  new  company's  charter  on  account  of  the  sim- 
ilarity in  name.  Under  such  circumstances  the  only 
remedy  of  the  older  company  would  be  to  bring  suit  in 
the  courts.  Some  states  lay  down  certain  arbitrary 
rules,  such  as  that  the  prefix  "The"  must  be  used,  or  that 
the  word  "incorporated"  or  "limited"  must  follow  the 
corporate  name.  Alabama,  Colorado,  Kentucky,  Con- 
necticut, Delaware,  Kansas,  Missouri,  North  Carolina 
and  Virginia  require  the  word  "company"  to  be  a  part 
of  the  corporate  name.  As  a  matter  of  business,  it  is 
usually  very  desirable  for  a  new  corporation  to  adopt 
some  distinctive,  self-explanatory,  short  name,  and  to 
avoid  so  far  as  possible  hackneyed  words  and  phrases. 

20.  The  corporate  purposes. — There  is  no  more  im- 
portant section  of  the  charter  than  that  in  which  the 


LEGAL  STATUS  OF  THE  CORPORATION   25 

corporate  purpose  or  purposes  are  stated.  For  most 
corporations,  the  activities  of  which  are  to  be  confined  to 
some  one  Hne  of  business,  a  brief  and  simple  statement 
is  all  that  is  necessary.  The  incorporators  and  their 
attorney  should  bear  in  mind  in  this  connection,  however, 
that  it  costs  nothing  at  the  beginning  to  insert  a  very 
full  and  comprehensive  description  of  all  the  possible 
activities  of  the  corporation  and  that  the  absence  of  the 
right  word  or  phrase  may  at  some  future  time  cause 
serious  inconvenience.  The  corporation  is  not  obliged  to 
carry  out  all  of  the  purposes  named  in  the  charter;  on 
the  other  hand,  it  has  no  authority  to  do  anything  which  is 
not  so  named  or  clearly  implied.  The  courts,  to  be  sure 
are  generally  liberal  in  their  interpretation  of  the  implied 
powers  of  corporations;  but  it  is  better  to  keep  out  of 
the  courts  and  to  take  a  little  care  at  the  beginning  so 
as  to  avert  any  future  disputes  as  to  whether  proposed 
activities  are  beyond  the  purposes  and  powers  of  the 
corporation  or  not. 

To  illustrate  the  care  with  which  the  purposes  of  a 
large  company  are  stated  in  order  to  comprehend  and 
give  legal  authority  for  any  possible  future  activity,  the 
charter  of  the  United  Steel  Corporation,  which  was 
drawn  by  one  of  the  greatest  corporation  lawyers  of  the 
United  States,  Judge  James  B.  Dill,  of  New  Jersey, 
may  be  cited.  The  section  of  the  charter,  in  which  the 
purposes  of  this  great  corporation  are  stated,  is  too  long 
to  be  quoted  in  full.  Nine  paragraphs  are  devoted  to 
describing  all  the  manufacturing,  landowning,  mining, 
trading,  contracting,  inventing  and  patenting,  security- 
buying,  selling  and  holding  activities  which  could  be 
thought  of  by  all  the  eminent  lawyers  and  business  men 
who  helped  Judge  Dill  to  draw  the  charter.  Then 
follow  the  two  paragraphs  quoted  below,  in  which,  as 


£6  CORPORATION  FINANCE 

the  reader  will  observe,  the  incorporators  aim  to  provide 
for  any  other  possible  activity  not  already  distinctly  set 
forth.  Note  particularly  the  italicized  clauses.  A  state- 
ment somewhat  similar  to  these  two  paragraphs  might 
be  included  to  advantage  in  the  charters  of  many  much 
smaller  corporations,  and  perhaps  would  dispose  of 
otherwise  troublesome  questions  of  authority. 

The  business  or  purpose  of  the  Company  is  from  time  to  time 
to  do  any  one  or  more  of  the  acts  and  things  herein  set  forth ; 
and  it  may  conduct  its  business  in  other  States  and  in  the  Terri- 
tories and  in  foreign  countries,  and  may  have  one  office  or  more 
than  one  office,  and  keep  the  books  of  the  company  outside  the 
State  of  New  Jersey,  except  as  otherwise  may  be  provided  by 
law;  and  may  hold,  purchase,  mortgage  and  convey  real  and 
personal  property  either  in  or  out  of  the  State  of  New  Jersey. 

Without  in  any  particular  limiting  any  of  the  objects  and 
powers  of  the  corporation,  it  is  hereby  expressly  declared  and 
provided  that  the  corporation  shall  have  power  to  issue  bonds 
and  other  obligations  in  payment  for  property  purchased  or  ac- 
quired by  it,  or  for  any  other  object  in  or  about  its  business; 
to  mortgage,  or  pledge  any  stocks,  bonds,  or  other  obliga- 
tions, or  any  property  which  may  be  acquired  by  it,  to  secure 
any  bonds  or  other  obligations  by  it  issued  or  incurred ;  to  guar- 
antee any  dividends  or  bonds  or  contracts  or  other  obligations ; 
to  make  and  perform  contracts  of  any  kind  and  description ;  and 
in  carrying  on  its  business,  or  for  the  purpose  of  attaining  or 
furthering  any  of  its  objects,  to  do  any  and  all  other  acts,  and 
things,  and  to  exercise  any  and  all  other  powers  which  a  co- 
partnership  or  natural  person  could  do  and  exercise,  and  which 
now  or  hereafter  may  he  authorized  by  law. 

A  further  illustration  of  the  importance  of  a  clear  and 
full  statement  in  the  charter  of  the  purposes  for  which  a 
corporation  is  organized  is  contained  in  a  decision  of  the 
New  Jersey  Court  of  Errors  and  Appeals  handed  down 
March  5,  1909.     The  c^s^  involved  the  right  of  a  rail- 


LEGAL  STATUS  OF  THE  CORPORATION         21 

road  company  to  acquire  and  hold  the  stock  of  certain 
trolley  companies  near  Atlantic  City.  The  court  de- 
nied this  right  and  said,  among  other  things: 

The  power  to  purchase,  hold,  etc.,  stock  and  bonds  of  other 
corporations  conferred  by  Section  51  of  the  general  corporation 
act  is  to  be  exercised  subject  to  the  limitations  imposed  by  Sec- 
tion 2  of  the  same  act ;  that  is  to  say,  the  power  exists  as  a  pri- 
mary power  only  when  the  purpose  to  exercise  it  as  such  is 
expressed  in  the  certificate  of  incorporation;  and  otherwise  it 
exists  as  an  incidental  power  only  so  far  as  necessary  or  con- 
venient to  the  attainment  of  the  objects  that  are  set  forth  in  the 
charter  or  certificate  of  incorporation.  It  is  only  by  reference 
to  the  certificate  of  incorporation  that  the  Attorney  General 
and  other  officials  interested  on  behalf  of  the  people  can  readily 
determine  what  powers  have  been  granted  and  whether  the 
company  is  usurping  franchises  not  granted  by  the  state.  It 
is  by  reference  to  the  articles  of  association  that  investors  can 
conveniently  ascertain  the  character  of  the  contract  into  which 
they  are  entering  and  the  property  rights  they  are  acquiring  in 
purchasing  stock  of  the  company. 

It  must  not  be  forgotten  that  stock  ownership  by  one  com- 
pany in  another  is  only  a  mode  by  which  the  former  company 
engages  in  the  business  of  the  latter.  But  since  the  second  com- 
pany (if  Section  51  were  unqualified  in  its  effect)  might  like- 
wise hold  stock  in  any  other  corporation  or  corporations,  and 
these  might  do  the  same  ad  infinitum,  stock  ownership  in  any 
company  under  such  a  system  would  not  evidence  a  participation 
in  any  definite  kind  of  business,  but  in  effect  a  participation  in  a 
"blind  pool"  subject  to  the  uncontrolled  will  of  the  majority. 
There  would  be  an  end  at  once  of  all  practical  force  to  the  doc- 
trine that  incorporation  evidences  a  contract  between  the  state 
and  the  corporation  or  between  the  corporators  and  stockholders 
themselves. 

Evidently  the  eminent  lawyers  who  drew  up  the 
charter,  or  certificate  of  incorporation,  of  the  railroad 


28  CORPORATION  FINANCE 

company  in  this  instance  were  either  careless  or  lacking 
in  foresight.  Otherwise,  they  would  have  avoided  this 
adverse  decision  very  easily  by  including  among  the 
powers  granted  by  the  charter  the  right  to  acquire  and 
hold  stock. 

21.  Other  important  features  of  the  charter, — The 
amount  of  capital  and  the  number  of  shares  of  a  new 
corporation  which  are  desirable  depend  on  principles  of 
capitalization  that  are  discussed  in  Chapter  VII  and 
which  need  not  be  considered  at  this  stage. 

Most,  though  not  all,  of  the  state  laws  require  that  the 
principal  office  of  the  corporation  shall  be  within  the  state 
where  the  charter  is  secured.  Partly  for  this  reason, 
other  things  being  equal,  it  is  better  to  secure  a  charter 
from  that  state  in  which  most  of  the  business  of  a  corpo- 
ration is  carried  on ;  but  this  is  by  no  means  an  invariable 
rule,  as  will  be  pointed  out  in  Chapter  IV.  It  is  also 
usual,  although  not  universal,  to  provide  that  one  or 
more  of  the  incorporators  shall  be  citizens  of  the  state 
which  grants  the  charter.  The  minimum  number  of  in- 
corporators in  most  states  is  three. 

The  number  of  directors  of  a  new  corporation  is  an 
important  point  to  consider  when  the  charter  is  obtained. 
Sometimes  the  number  is  stated  not  in  the  charter,  but  in 
the  by-laws  and  may  readily  be  amended  from  time  to 
time;  but  where  the  number  is  fixed  by  the  charter  it 
cannot  be  easily  changed.  A  small  board  obviously  is 
apt  to  be  more  efficient  than  a  large  board.  This  is 
another  question  which  will  come  up  for  fuller  discussion 
in  a  subsequent  chapter. 

22.  The  by-laws, — The  by-laws  are  simply  a  collec- 
tion of  permanent  rules  for  transacting  business  adopted 
by  the  stockholders  or  directors.  It  is  not  absolutely 
necessary,  though  almost  always  very  desirable,  that  a 


LEGAL  STATUS  OF  THE  CORPORATION   29 

corporation  should  have  by-laws.     ,The  by-laws  usually 
contain  provisions  as  to: 

(1)  Issue  and  transfer  of  stock. 

(2)  Meetings  of  stockholders  and  directors. 

(3)  Election  of  directors  and  officers. 

(4)  Powers  and  duties  of  directors  and  officers. 

(5)  General  directions  as  to  the  management  of  the 
corporate  property. 

As  in  the  case  of  the  charter,  we  will  run  over  briefly 
some  of  the  important  features  of  corporate  by-laws. 

First,  the  reader  should  study  with  care  the  following 
set  of  by-laws,  which  is  used  by  a  New  York  corporation, 
but  could  be  adapted  with  slight  changes  to  any  small 
company.  This  set  is  taken  from  Mr.  Conyngton's  ex- 
cellent manual,  '*The  Modern  Corporation." 

BY-LAWS 

OF  THE 

STANDARD  BLEACHING  COMPANY, 

NEW  YORK  CITY 


Article   I. — Stock. 

1.  Certificates  of  Stock  shall  be  issued  in  numerical  order  from 
the  stock  certificate  book,  be  signed  by  the  President  and  Treas- 
urer and  sealed  by  the  Secretary  with  the  corporate  seal.  A 
record  of  each  certificate  issued  shall  be  kept  on  the  stub  thereof. 

2.  Transfers  of  Stock  shall  be  made  only  upon  the  books  of 
the  Company  and  before  a  new  certificate  is  issued  the  old  cer- 
tificate must  be  surrendered  for  cancellation.  The  stock  books 
of  the  Company  shall  be  closed  for  transfers  twenty  days  before 
general  elections  and  ten  days  before  dividend  days. 

3.  The  Treasury  Stock  of  the  Company  shall  consist  of  such 
issued  and  outstanding  stock  of  the  Company  as  may  be  do- 
nated to  the  Company  or  otherwise  acquired,  and  shall  be  held 
subject  to  disposal  by  the  Board  of  Directors.     Sucl^  stock 


30  CORPORATION  FINANCE 

shall  neither  vote  nor  participate  in  dividends  while  held  by  the 
Company. 

Article  II. — Stockholders. 

1.  The  Annual  Meeting  of  the  stockholders  of  this  Company 
shall  be  held  in  the  principal  office  of  the  Company  in  New 
York  City  at  12  M.  on  the  second  Monday  in  January  of  each 
year,  if  not  a  legal  holiday,  but  if  a  legal  holiday  then  on  the 
day  following. 

2.  Special  Meetings  of  the  stockholders  may  be  called  at  the 
principal  office  of  the  Company  at  any  time  by  resolution  of  the 
Board  of  Directors,  or  upon  written  request  of  stockholders 
holding  one-third  of  the  outstanding  stock. 

3.  Notice  of  Meetings,  written  or  printed,  for  every  regular 
or  special  meeting  of  the  stockholders,  shall  be  prepared  and 
mailed  to  the  last  known  post-office  address  of  each  stockholder 
not  less  than  ten  days  before  any  such  meeting,  and  if  for  a 
special  meeting,  such  notice  shall  state  the  object  or  objects 
thereof.  No  failure  or  irregularity  of  notice  of  any  regular 
meeting  shall  invalidate  such  meeting  or  any  proceeding 
thereat. 

4.  A  Quorum  at  any  meeting  of  the  stockholders  shall  con- 
sist of  a  majority  of  the  voting  stock  of  the  Company,  repre- 
sented in  person  or  by  proxy.  A  maj  ority  of  such  quorum  shall 
decide  any  question  that  may  come  before  the  meeting. 

5.  The  election  of  Directors  shall  be  held  at  the  annual  meet- 
ing of  stockholders  and  shall,  after  the  first  election,  be  con- 
ducted by  two  inspectors  of  election  appointed  by  the  Presi- 
dent for  that  purpose.  The  election  shall  be  by  ballot,  and 
each  stockholder  of  record  shall  be  entitled  to  cast  one  vote  for 
each  share  of  stock  held  by  him. 

6.  The  Order  of  Business  at  the  annual  meeting,  and,  as  far 
as  possible,  at  all  other  meetings  of  the  stockholders,  shail  be : 

1.  Calling  of  Roll. 

2.  Proof  of  due  notice  of  Meeting. 

3.  Reading  and  disposal  of  any  unapproved  Minutes. 

4.  Annual  Reports  of  Officers  and  Committees. 


LEGAL  STATUS  OF  THE  CORPORATION        31 

5.  Election  of  Directors. 

6.  Unfinished  Business, 

7.  New  Business. 

8.  Adjournment. 

Article  III. — Directors. 

1.  The  Business  and  Property  of  the  Company  shall  be  man- 
aged by  a  Board  of  seven  Directors,  who  shall  be  stockholders 
and  who  shall  be  elected  annually  by  ballot  by  the  stockholders 
for  the  term  of  one  year,  and  shall  serve  until  the  election  and 
acceptance  of  their  duly  qualified  successors.  Any  vacancies 
may  be  filled  by  the  Board  for  the  unexpired  term.  Directors 
shall  receive  no  compensation  for  their  services. 

2.  The  Regular  Meetings  of  the  Board  of  Directors  shall 
be  held  in  the  principal  office  of  the  Company  in  New  York 
City  at  3  P.  M.  on  the  third  Tuesday  of  each  month,  if  not  a 
legal  holiday,  but  if  a  legal  holiday,  then  on  the  day  following. 

3.  Special  Meetings  of  the  Board  of  Directors  to  be  held  in 
the  principal  office  of  the  Company  in  New  York  City  may  be 
called  at  any  time  by  the  President,  or  by  any  three  members  of 
the  Board,  or  may  be  held  at  any  time  and  place,  without  notice, 
by  unanimous  written  consent  of  all  the  members,  or  with  the 
presence  of  all  members  at  such  meetings. 

4.  Notices  of  both  regular  and  special  meetings  shall  be 
mailed  by  the  Secretary  to  each  member  of  the  Board  not  less 
than  five  days  before  any  such  meeting,  and  notices  of  special 
meetings  shall  state  the  purposes  thereof.  No  failure  or  irregu- 
larity of  notice  of  any  regular  meeting  shall  invalidate  such 
meeting  or  any  proceeding  thereat. 

5.  A  Quorum  at  any  meeting  shall  consist  of  a  majority  of 
the  entire  membership  of  the  Board.  A  majority  of  such 
quorum  shall  decide  any  question  that  may  come  before  the 
meeting. 

6.  Officers  of  the  Company  shall  be  elected  by  ballot  by  the 
Board  of  Directors  at  their  first  meeting  after  the  election  of 
directors  each  year.  If  any  office  becomes  vacant  during  the 
year,  the  Board  of  Directors  shall  fill  the  same  for  the  unex- 


S2  CORPORATION  FINANCE 

pired  term.     The  Board  of  Directors  shall  fix  the  compensa- 
tion of  the  officers  and  agents  of  the  Company. 

7.  The  order  of  business  at  any  regular  or  special  meeting 
of  the  Board  of  Directors  shall  be: 

1.  Reading  and  disposal  of  any  unapproved  Minutes. 

S.  Reports  of  Officers  and  Committees. 

3.  Unfinished  Business. 

4.  New  Business. 

5.  Adjournment. 

Article  IV.— Officers. 

1.  The  Officers  of  the  Company  shall  be  a  President,  a  Vice- 
President,  a  Secretary  and  a  Treasurer,  who  shall  be  elected 
for  one  year  and  shall  hold  office  until  their  successors  are 
elected  and  qualify.  The  positions  of  Secretary  and  Treasurer 
may  be  united  in  one  person. 

2.  The  President  shall  preside  at  all  meetings,  shall  have  gen- 
eral supervision  of  the  affairs  of  the  Company,  shall  sign  or 
countersign  all  certificates,  contracts  and  other  instiniments  of 
the  Company  as  authorized  by  the  Board  of  Directors;  shall 
make  reports  to  the  directors  and  stockholders  and  perform  all 
such  other  duties  as  are  incident  to  his  office  or  are  properly  re- 
quired of  him  by  the  Board  of  Directors.  In  the  absence  or 
disability  of  the  President,  the  Vice-President  shall  exercise  all 
his  functions. 

3.  The  Secretary  shall  issue  notices  for  all  meetings,  shall 
keep  their  minutes,  shall  have  charge  of  the  seal  and  the  cor- 
porate books,  shall  sign  with  the  President  such  instruments  as 
require  such  signature,  and  shall  make  such  reports  and  per- 
form such  other  duties  as  are  incident  to  his  office,  or  are  prop- 
erly required  of  him  by  the  Board  of  Directors. 

4.  The  Treasurer  shall  have  the  custody  of  all  moneys  and 
securities  of  the  Company  and  shall  keep  regular  books  of  ac- 
count and  balance  the  same  each  month.  He  shall  sign  or  coun- 
tersign such  instruments  as  require  his  signature,  shall  perform 
all  duties  incident  to  his  office  or  that  are  properly  required  of 
him  by  the  Board,  and  shall  give  bond  for  the  faithful  perform- 


LEGAL  STATUS  OF  THE  CORPORATION        33 

ance  of  his  duties  in  such  &um  and  with  such  sureties  as  may  be 
required  by  the  Board  of  Directors. 

Article  V. — Dividends  and  Finance. 

1.  Dividends  shall  be  declared  only  from  the  surplus  profits  at 
such  times  as  the  Board  of  Directors  shall  direct,  and  no  divi- 
dend shall  be  declared  that  will  impair  the  capital  of  the  Com- 
pany. 

2.  The  moneys  of  the  Company  shall  be  deposited  in  the  name 
of  the  Company  in  such  bank  or  trust  company  as  the  Board  of 
Directors  shall  designate,  and  shall  be  drawn  out  only  by  check 
signed  by  the  Treasurer  and  countersigned  by  the  President. 

Article  VI.— Seal. 
1.  The  Corporate  Seal  of  the  Company  shall  consist  of  two 
concentric  circles,  between  which  Is  the  name  of  the  Company, 
and  In  the  centre  shall  be  Inscribed  "Incorporated  1905,  New 
York,"  and  such  seal,  as  Impressed  on  the  margin  hereof,  is 
hereby  adopted  as  the  Corporate  Seal  of  the  Company. 

Article  VII. — Amendments. 

1.  These  By-Laws  may  be  amended,  repealed  or  altered,  In 
whole  or  In  part,  by  a  majority  vote  of  the  entire  outstanding 
stock  of  the  Company,  at  any  regular  meeting  of  the  stock- 
holders, or  at  any  special  meeting  where  such  action  has  been 
announced  in  the  call  and  notice  of  such  meeting. 

2.  The  Board  of  Directors  may  adopt  additional  by-laws  in 
harmony  therewith,  but  shall  not  alter  nor  repeal  any  by-laws 
adopted  by  the  stockholders  of  the  Company. 

23.  Essential  features  of  the  by-laws. — The  sections 
with  regard  to  stock  are  usually  of  a  formal  character 
and  state  simply  that  the  ownership  of  stock  shall  be 
evidenced  by  the  issue  of  certificates  to  each  stockholder, 
and  that  transfers  of  ownership  shall  be  made  only  upon 
the  books  of  the  company.  The  reader  should  thor- 
oughly understand  this  provision,  which  is  practically 
universal.     Frequently  the  engraved  certificate  of  stock 

1—3 


34.  CORPORATION  FINANCE 

in  the  possession  of  a  stockholder,  which  usually  reads 
"This  is  to  certify  that  John  Doe  is  the  owner  of  . . 
shares  of  the  capital  stock  of  the  John  Doe  Company, 
transferable  only  on  the  books  of  the  company,  etc.," 
(see  page  70)  is  incorrectly  called  and  mistaken  for 
stock  itself.  As  a  matter  of  fact,  stock  is  an  intangible 
thing;  it  is  merely  a  right  to  a  share  in  the  company's 
assets  and  earnings.  A  certificate  is  only  a  convenient 
method  of  proving  that  a  certain  person  is  the  owner  of 
stock.  A  certificate  may  be  lost  or  stolen  or  given  away^ 
or  sold  and  yet  the  ownership  of  the  stock  will  remain 
unchanged.  Only  by  transfer  on  the  books  of  the  com- 
pany will  a  change  in  ownership  be  consummated.  The 
usual  method  of  transferring  stock  is  to  sign  a  blank 
form  on  the  back  of  each  certificate  (see  page  70)  which 
authorizes  the  secretary  of  the  corporation  or  some  other 
agent  of  the  owner  to  make  the  transfer. 

The  by-laws  almost  always  specify  the  time  and  place 
of  an  annual  meeting  of  stockholders  for  the  transaction 
of  important  business.  Special  meetings  may  be  called 
from  time  to  time  on  request  of  a  certain  number  of 
stockholders  or  in  whatever  manner  the  by-laws  may 
lay  down.  The  important  point  is  that  to  make  a  special 
meeting  legal  every  stockholder  must  have  proper  notice 
in  writing  mailed  to  his  last-known  address.  Meetings 
of  the  directors  also  are  usually  required  at  stated  inter- 
vals and  it  is  set  forth  in  the  by-laws  that  the  directors 
are  to  elect  the  officers  of  the  company  and  to  otherwise 
manage  its  affairs. 

The  essential  officers  of  a  corporation  are  the  presi- 
dent, the  secretary  and  the  treasurer.  The  duties  of 
each  officer  should  be  and  usually  are  clearly  specified 
in  the  by-laws.  Ordinarily  the  president,  briefly  stated, 
is  the  chief  executive  officer;  the  secretary  keeps  the 


LEGAL  STATUS  OF  THE  CORPORATION   35 

records  of  the  corporation;  the  treasurer  handles  the 
corporate  funds.  The  reader  should  clearly  understand, 
however,  that  this  definition  of  duties  is  not  necessarily 
or  universally  followed.  The  by-laws  may  make  the 
president  the  custodian  of  funds  and  the  treasurer  the 
chief  executive  officer,  or  may  distribute  the  duties  in  any 
other  manner.  The  law  recognizes,  however,  that  an 
outsider  has  the  right  to  assume  that  the  man  who 
is  given  the  title  of  president,  treasurer  or  secretary  is 
given  the  powers  and  duties  that  customarily  belong  to 
that  position. 

The  by-laws  usually  declare  that  dividends  shall  be 
paid  only  out  of  earnings,  not  out  of  the  capital  of  the 
corporation,  although  this  is  simply  a  formal  statement 
of  a  principle  which  could  not  legally  be  violated  in 
any  case  so  long  as  the  corporation  has  creditors.  A 
corporate  seal  is  usually  adopted  and  briefly  described 
in  the  by-laws.  The  procedure  and  necessary  percent- 
age of  favorable  votes  in  order  to  amend  the  by-laws 
are  usually  stated. 

The  board  of  directors  or  the  stockholders  may  some- 
times adopt  new  rules  of  action  which  will  be  binding 
until  rescinded,  without  the  formality  of  amending  the 
by-laws,  simply  by  passing  a  formal  resolution.  No 
resolution,  it  need  scarcely  be  said,  will  be  legally  bind- 
ing if  it  is  contrary  to  any  by-law  provision.  Resolu- 
tions are  frequently  used,  however,  to  supplement  and 
further  elucidate  the  by-laws  and  to  lay  down  a  general 
permanent  policy. 

We  have  now  covered  very  briefly  the  main  points 
that  the  reader  should  bear  in  mind  as  to  the  legal  status 
of  the  corporation  and  as  to  the  instruments  that  confer 
and  define  that  status.  All  this  is  rather  dry  and 
more  or  less  technical  matter;  yet  it  must  not  be  sfurred 


36  CORPORATION  FINANCE  «^ 

over  by  anyone  who  desires  to  acquire  that  knowledge 
of  the  corporate  form  and  understanding  of  its  uses  and 
misuses  that  is  essential  to  every  person  successfully 
concerned  with  modern  business.  We  cannot  afford  to 
forget  that  the  corporation  is  created  and  maintained 
under  certain  specific  provisions  of  the  law  to  which  all 
its  actions  must  conform. 


CHAPTER  III 

INTERIOR  ORGANIZATION 

24.  Rights  of  stockholders,— In  this  chapter  we  will 
treat  as  briefly  as  the  subject  will  permit  the  relations 
to  each  other  of  the  various  groups  of  individuals  who 
are  interested  in  a  corporation.    Those  groups  are: 

I.  Stockholders, 
II.  Creditors. 

III.  Directors. 

IV.  Officers. 

Every  corporation  must  be  so  organized  that  the  duties, 
the  liabilities  and  the  rights  of  each  of  these  groups  are 
clearly  known  and  may  be  enforced. 

The  nature  of  stock — the  fact  that  it  is  an  intangible 
share  in  the  corporation's  assets  and  earnings — ^has  al- 
ready been  discussed.  Each  owner  of  stock  becomes  to 
the  extent  of  his  holdings  an  owner  of  the  corporation. 
His  rights  fundamentally  are  the  same  as  the  rights  ofi 
other  owners  of  private  property,  but  the  full  exercise 
of  these  rights  is  under  the  corporate  form  much 
abridged  and  modified.  To  illustrate,  the  private  owner 
of  a  piece  of  property  has  the  right  to  sell  or  destroy  or 
give  away  or  use  for  his  personal  enjoyment  the  prop- 
erty and  its  earnings.  A  stockholder,  however,  cannot 
sell  or  destroy  or  otherwise  tamper  with  his  proportion 
of  the  corporation's  assets,  because  under  the  corporate 
form  he  has  committed  those  assets  to  the  care  of  other 
people. 

37; 


38  CORPORATION  FINANCE 

The  rights  of  stockholders  as  a  body  are : 

(1)  To  elect  directors. 

(2)  To  amend  the  charter  or  by-laws. 

(3)  To  sanction  or  veto  the  selling  or  mortgaging  of 
the  permanent  assets  of  the  corporation. 

(4)  To  dissolve  the  company. 

The  first  two  rights  have  been  touched  upon  in  the 
preceding  chapter  and  need  not  be  further  considered. 
The  third  right  is  not  universal  in  all  states  and  under 
all  charters,  but  is  generally  conceded.  In  some  states 
the  courts  assume  that  the  stockholders,  having  chosen 
directors,  freely  turn  over  to  them  the  sole  and  complete 
management  of  the  business  without  any  reservations 
whatsoever.  Even  in  such  states,  however,  the  directors, 
in  order  to  avoid  any  charge  of  fraud  that  might  be 
brought  against  them,  generally  prefer  on  such  impor- 
tant actions  as  the  sale  of  permanent  assets  to  have  the 
officially  expressed  concurrence  of  the  stockholders.  A 
clause  is  sometimes  placed  either  in  the  charter  or  in  the 
by-laws  requiring  unanimous  consent  or  the  consent  of 
a  very  large  percentage  of  the  stockholders  in  order  to 
validate  a  sale  or  mortgage  of  permanent  assets.  The 
right  of  dissolution  is  very  seldom  exercised  inasmuch 
as  an  unsuccessful  corporation  may  be  very  easily  aban- 
doned and  its  charter  allowed  to  lapse  by  non-payment 
of  taxes. 

25;  The  proxy  and  its  uses. — The  rights',  of  each  in- 
dividual stockholder  are  four  in  number,  as  follows: 

(1)  To  receive  notice  of  and  to  participate  in  all 
stockholders'  meetings. 

(2)  To  share  in  the  assets  of  the  corporation  in  pro- 
portion to  his  stockholdings  in  case  of  dissolution. 

(3)  To  share  in  dividends  declared  by  the  directors 
in  proportion  to  his  stockholdings. 


INTERIOR  ORGANIZATION  39 

(4)   To  inspect  the  accounts  of  the  corporation. 

The  first  right  has  ah-eady  been  mentioned.  It  should 
be  further  observed,  however,  that  a  stockholder's  right 
to  participate  in  meetings  is  not  confined  to  personal 
attendance  at  the  meetings.  If  he  does  not  go  himself 
he  may  confer  the  right  to  represent  him  upon  some 
other  person.  The  instrument  which  confers  this  right 
is  known  as  a  "proxy"  and  generally  reads  somewhat  as 
follows : 

KNOW  ALL  MEN  BY  THESE  PRESENTS,  that  I,  the 
undersigned,  do  hereby  constitute  and  appoint  John  Doe  my 
true  and  legal  attorney  to  represent  me  at  all  meetings  of  the 
stockholders  of  the  Blank  Company.  And  for  me  and  in  my 
name  and  stead  to  vote  throughout  upon  the  stock  standing 
in  my  name  on  the  books  of  said  company  at  the  times  of 
said  meetings,  and  I  hereby  grant  my  said  attorney  all  the 
powers  that  I  should  possess  if  personally  present. 

This  is  a  form  well  adapted  to  conferring  a  simple,  un- 
limited right  to  represent  the  stockholder  who  gives  it. 
The  proxy  may  be  much  more  formal  and  may  contain 
any  limitations  that  the  giver  chooses  to  impose;  for  in- 
stance, it  may  be  good  only  for  one  meeting  or  up  to  a 
certain  time  or  for  a  certain  purpose,  such  as  giving  an 
affirmative  vote  on  a  proposition  that  is  to  come  before 
the  meeting. 

The  use  of  proxies, in  this  country  is  widespread  and 
is  an  important  feature  of  corporation  management. 
In  England  stockholders  are  more  likely  to  appear  in 
person  at  the  annual  meetings.  By  means  of  proxies 
American  corporation  officials  are  accustomed  to  hold 
meetings  with  no  one  but  themselves  actually  attending, 
but  with  a  constructive  attendance  through  their  proxies 
of  more  than  a  majority  of  the  outstanding  stock.     The 


40  CORPORATION  FINANCE 

Union  Pacific  Railroad,  for  instance,  which  is  incorpo- 
rated in  Utah  and  must  hold  its  annual  meetings  in  that 
state,  whereas  its  principal  office  is  in  New  York  City, 
every  year  sends  its  secretary  and  a  few  minor  officials 
from  New  York  to  Salt  Lake  City,  each  official  carrying 
a  satchel  full  of  proxies.  The  annual  meeting  is  then 
held  and  the  election  of  directors  carried  out  with  all  the 
formality  that  would  characterize  a  fully  attended  meet- 
ing. Any  lone  stockholder  who  appears  in  person  will 
find  that  his  presence  adds  nothing  to  the  effectiveness 
of  the  proceedings  and  does  not  change  their  character 
in  the  least.  Of  course,  in  smaller  companies  the  stock- 
holders are  more  likely  to  be  present  in  person,  although 
even  there  representation  by  proxy  is  the  estabhshed 
custom. 

One  point  about  a  proxy  that  should  be  impressed  on 
the  mind  of  every  stockholder  is  that  it  is  never  under 
any  circumstances  irrevocable.  The  courts  will  not  rec- 
ognize an  irrevocable  proxy  as  a  valid  agreement.  No 
matter  what  the  wording  of  the  original  proxy  may  be, 
no  matter  if  it  clearly  and  emphatically  states  that  it  is 
irrevocable,  a  stockholder  may,  as  a  matter  of  fact  and 
of  law,  revoke  it  at  his  will. 

The  second  right,  as  has  already  been  intimated,  is  of 
small  practical  importance. 

26.  The  right  to  dividends, — The  third  right — to 
share  in  dividends — is  so  often  misunderstood  by  stock- 
holders that  its  limitations  need  to  be  carefully  noted. 
In  the  first  place,  notice  that  nothing  is  said  as  to  earn- 
ings. A  corporation  may  be  getting  enormous  yearly 
profits  and  yet  an  individual  stockholder  may  not  draw 
any  dividends  whatever;  nor  can  the  stockholder  get  at 
these  earnings  until  dividends  are  declared.  In  the 
second  place,  it  will  be  pointed  out  in  connection  with  the 


INTERIOR  ORGANIZATION  41 

powers  of  directors  that  directors  alone  have  the  right 
to  declare  dividends  and  cannot  be  compelled  by  any- 
legal  action  whatever  to  grant  dividends  to  the  stock- 
holders until  they  see  fit.  A  case  in  point,  which  at- 
tracted some  attention  several  years  ago,  was  that  of  the 
Midvale  Steel  Company,  a  fairly  large  and  now  pros- 
perous company,  located  in  a  suburb  of  Philadelphia. 
The  management  of  the  company  for  the  ten  years  1887 
to  1897  devoted  all  of  its  earnings  to  improvement  of 
the  plant,  in  spite  of  protests  and  strenuous  efforts  on 
the  part  of  minority  stockliolders  to  force  the  declaration 
of  dividends.  The  courts  will  not  interfere  with  the 
policy  of  the  board  of  directors  in  this  regard  unless 
fraud  or  mismanagement  can  be  proved. 

27.  The  right  to  information, — The  fourth  right — to 
inspect  the  corporate  books  and  accounts — ^was  originally 
universally  admitted  and  was  of  considerable  impor- 
tance. Each  stockholder  could  go  into  the  company's 
office  whenever  he  chose  and  demand  that  he  be  given 
access  to  all  the  books  and  accounts.  Early  in  the  his- 
tory of  business  corporations,  however,  it  became  evident 
that  the  manager  of  a  rival  business  could  buy  a  single 
share  of  stock  and  thereby  obl:ain  trade  information  that 
could  be  used  to  the  detriment  of  the  corporation.  Thus 
the  anomaly  was  presented  of  a  stockholder  of  a  corpo- 
ration being  able  to  work  against  the  corporation's  in 
terests.  The  courts,  recognizing  the  situation,  have 
greatly  modified  and  almost  nullified  this  original  right. 
No  stockholder  can  now  on  legal  grounds  demand  that 
he  be  furnished  with  information  as  to  the  customers  of 
the  corporation,  the  persons  from  whom  supplies  are 
bought  and  their  prices,  the  corporation's  contracts,  and 
other  points  of  similar  nature.  In  most  states  he  gets 
all  the  information  that  rightfully-  belongs  to  hinl  if  he 


42  CORPORATION  FINANCE 

obtains  simply  a  summary  of  the  profit  and  loss  account 
for  the  preceding  year  and  of  the  balance  sheet  at  the 
end  of  the  corporation's  fiscal  year.  Indeed,  he  cannot 
in  all  states  secure  even  this  meagre  and  apparently  in- 
nocuous information. 

The  movement  in  favor  of  publicity  of  corporate  ac- 
counts, however,  is  now  so  general  and  strong,  and  the 
force  of  public  opinion  behind  it  is  so  great,  that  almost 
all  the  important  corporations  voluntarily  give  to  their 
stockholders  and  to  the  public  fairly  complete  annual 
reports.  Railroads  particularly  under  the  Interstate 
Commerce  Act,  as  amended  in  1906,  are  compelled  to 
render  to  the  Interstate  Commerce  Commission  and 
through  the  Commission  to  the  public  and  to  their  stock- 
holders, a  very  complete  and  detailed  summary  of  their 
operations  each  year.  One  striking  exception  among 
the  large  corporations  to  this  general  tendency  toward 
increased  publicity  is  the  Standard  Oil  Company,  whose 
management  has  never  yet  given  out  anything  more  than 
a  bare  statement  of  the  amount  of  the  capitalization  and 
of  the  dividends  declared.  Publicity  of  accounts  is  not 
to  be  confused  with  the  right  of  the  individual  stock- 
holder to  have  access  to  the  corporatipn's  books,  for  even 
the  greatest  degree  of  publicity  extends  only  to  general 
financial  results  of  the  corporation's  activities,  not  to  the 
corporation's  individual  purchases,  sales  and  contracts. 
The  right  to  actual  inspection  of  the  books,  with  few 
unimportant  exceptions,  is  entirely  a  theoretical,  not  a 
practically  important  attribute  of  stockholders. 

28.  Liabilities  of  stockholders, — The  next  topic  to 
consider  is  that  of  liabilities  of  stockholders,  which  may 
be  grouped  under  the  following  four  heads : 

( 1 )   Their  liabiHty  to  the  corporation  or  to  unsatisfied 


INTERIOR  ORGANIZATION  43 

creditors  of  the  corporation  for  unpaid  installments  on 
part-paid  stock. 

(2)  Their  liability  to  unsatisfied  creditors  of  the 
corporation  in  case  dividends  have  been  paid  out  of 
capital  assets. 

(3)  In  New  York  State,  their  liability  to  employees 
and  servants  for  wages  due  by  the  corporation. 

(4)  In  California  and  Minnesota,  their  liability  for 
all  the  debts  of  the  corporation  up  to  an  amount  equal 
to  the  face  value  of  tlieir  stockholdings.  In  the  case 
of  national  banks  the  same  rule  holds  good. 

A  few  other  exceptions  to  the  general  principle  that 
stockholders  as  individuals  are  not  liable  for  corporate 
debts  might  be  given,  but  would  be  out  of  place  in  this 
brief  and  general  review  of  corporation  law. 

With  further  reference  to  the  liability  first  stated  in 
the  preceding  paragraph,  it  should  be  observed  that  cor- 
porations frequently  do  not  need  at  the  beginning  of 
their  existence  all  the  capital  assets  that  will  later  be 
necessary.  They  therefore  ask  their  stockholders  to  pay 
only  a  certain  percentage  of  their  stock  subscriptions  at 
the  beginning  and  either  set  certain  dates  for  the  re- 
maining payments  or  leave  the  dates  to  be  fixed  later  by 
the  directors  of  the  company.  In  the  latter  case  it 
sometimes  happens  that  the  corporation  becomes  so  pros- 
perous that  the  unpaid  installments  are  not  called  for 
and  in  the  course  of  years  stockholders  may  almost 
forget  that  they  are  still  unpaid.  Then  if  the  corpora- 
tion later  gets  into  financial  difficulties,  the  owners  of 
stock  at  the  time  may  suddenly  find  themselves  con- 
fronted by  a  demand  for  the  inmiediate  payment  of  un- 
paid installments.  It  is  a  very  unpleasant  and  not 
especially  uncommon  situation.     Buyers  of  stock  should 


44  CORPORATION  FINANCE 

therefore  be  very  certain  that  their  certificates  are 
marked  "full  paid  and  non-assessable,"  or  else  make 
sure  that  they  can  meet  whatever  installments  are  un- 
paid, when  called  for,  without  great  inconvenience  to 
themselves. 

The  payment  of  dividends  out  of  capital  instead  of! 
out  of  earnings  is  a  practice  which  we  shall  have  occasion 
to  refer  to  later  in  this  volume.  All  that  need  be  said 
about  it  here  is  that  it  might  obviously  be  used  as  a  means 
of  diverting  to  stockholders  assets  pledged  to  creditors 
of  the  corporation  and  for  that  reason  is  not  permis- 
sible, if  any  objection  is  raised. 

29.  Rights  of  creditors.^^The  creditors  of  a  corpora- 
tion are  of  two  distinct  kinds,  secured  and  unsecured. 
The  secured  creditors  are  those  who  have  had  set  aside 
for  them  under  some  form  of  agreement  certain  parts 
of  the  property  of  the  corporation  which  are  to  be 
devoted,  in  case  the  corporation  fails  at  the  specified 
time  to  meet  its  debt,  to  paying  the  creditor  in  full. 
The  exact  procedure  will  be  discussed  at  some  length 
in  connection  with  corporate  notes  and  bonds.  The 
unsecured  creditors  hold  simply  a  claim  against  the 
general  unattached  assets  of  the  corporation. 

Whether  the  creditors  be  secured  or  unsecured,  they 
have  no  part  in  the  organization  or  management  of  the 
corporation  so  long  as  the  debts  to  them  are  fully  and 
promptly  met.  Only  in  case  of  insolvency  or  bank- 
ruptcy may  they  step  in  and  exercise  any  rights  which 
may  have  been  conditionally  granted  to  them.  We  will 
therefore  defer  a  study  of  their  place  in  the  corporate 
organization  until  we  come  to  the  subjects  of  insolvency, 
bankruptcy  and  reorganization. 

30.  "Dummy''  directors, — The  statutes  of  nearly  all 
the  states  require  that  the  directors  of  a  corporation 


I 


INTERIOR  ORGANIZATION  46 

shall  also  be  stockholders.  In  most  states  the  owner- 
ship of  a  single  share  is  sufficient  to  meet  this  re- 
quirement. As  an  example  of  the  striking  difference 
at  times  between  what  the  law  intends  and  what  it  ac- 
complishes, this  requirement  deserves  special  mention. 
Obviously  it  is  intended  to  prevent  any  one  man  from 
"packing"  the  board  of  directors;  in  practice  it  serves 
to  facilitate  the  creation  of  and  control  over  "dummy" 
directors. 

A  dummy  director  is  one  who  serves  the  interest  of 
some  other  person  and  who  votes  as  he  is  told.  Some- 
times he  is  an  actual  stockholder  or  is  given  stock  out- 
right in  order  to  qualify  him  for  his  position,  and  the 
man  who  controls  him  depends  on  influences  outside 
the  corporation  to  retain  his  control.  When  any 
doubt  exists  as  to  that  point,  however,  the  "dummy" 
director  usually  receives  a  certificate  of  stock  duly 
transferred  to  him  on  the  books  of  the  company — ^which 
thus  qualifies  him  to  act  as  director — but  is  required  to 
endorse  the  certificate  back  to  the  real  owner.  Thus 
the  owner  of  the  stock  always  has  a  string  tied  to  the 
"dummy"  director.  If  his  orders  are  not  followed  to 
his  satisfaction,  all  that  he  needs  to  do  is  to  send  in  the 
certificate,  have  the  stock  transferred  back  to  himself 
and  thereby  disqualify  the  "dummy."  Thus  a  major- 
ity stockholder  may  elect  a  whole  board  of  directors 
who  are  absolutely  subservient  to  his  orders  and  repre- 
sent only  his  interests.  He  may  not  himself  be  a 
member  of  the  board  at  all,  and  yet  may  dictate  its 
every  action. 

31,  Powers  and  liabilities  of  directors, — In  theory, 
however,  even  if  not  in  practice,  a  board  of  directors  is 
supposed  to  represent  all  the  stockholders  equally. 
Partly  for  that  reason  the  board,  as  has  already  been 


46'  CORPORATION  FINANCE 

indicated,  is  given  complete  control  over  the  corpora- 
tion's assets  and  officers.  Very  seldom,  indeed,  will  the 
courts  restrain  the  directors  from  taking  any  action 
short  of  selling  or  mortgaging  the  corporation's  perma- 
nent assets,  unless  fraud  or  wrongdoing  is  conclusively 
shown.  Their  powers  are  usually  more  or  less  modified, 
however,  by  the  corporation's  by-laws,  and,  like  other 
officers,  they  are  not  at  liberty  to  transgress  or  omit  any 
of  the  duties  specifically  set  forth  in  the  by-laws.  As 
a  general  thing  they  have  power  among  other  things 
to  fill  vacancies  in  their  own  number  until  the  next 
annual  meeting  of  the  stockholders  for  the  election  of 
directors,  to  appoint  and  remove  officers  of  the  corpo- 
ration, and  under  limitations  to  modify  or  enact  by-laws. 

Any  or  all  of  these  powers  the  board  of  directors 
may  delegate,  if  they  see  fit,  to  a  standing  committee 
chosen  from  their  number.  Where  the  board  of  direct- 
ors is  so  large  as  to  be  unwieldy  and  difficult  to  assemble 
at  regular  intervals,  such  delegation  of  powers  is  cus- 
tomary. The  board  of  directors  of  the  United  States 
Steel  Corporation,  for  example,  has  two  important 
standing  committees,  the  executive  and  the  finance. 
The  executive  committee  holds  frequent  meetings  and 
conferences  with  the  chairman  of  the  board  of  directors 
and  with  the  president  of  the  corporation  and  between 
meetings  of  the  full  board  of  directors  has  complete 
authority  to  settle  such  questions  as  would  come  before 
the  board.  The  finance  committee,  as  its  name  implies, 
handles  with  full  authority  such  financial  questions  as 
in  most  corporations  would  be  referred  to  the  board 
of  directors. 

The  usual  duties  of  corporation  officers  have  already 
been  treated  in  the  preceding  chapter.     One  officer  not 


INTERIOR  ORGANIZATION  47 

mentioned  there,  who  is  in  several  large  corporations 
of  much  importance,  is  the  chairman  of  the  board  of 
directors.  In  the  United  States  Steel  Corporation, 
the  New  York  Central  Railroad  Company,  the 
National  City  Bank  of  New  York,  and  other  companies 
of  like  magnitude,  the  chairman  of  the  board  of 
directors  is  a  prominent  paid  officer  to  whom  the  presi- 
dent of  the  corporation  reports.  It  would  not  be  far 
from  wrong  to  say  that  the  chairman  represents  the 
board  of  directors  and  the  standing  committees  of  the 
board  in  the  intervals  between  meetings.  To  him,  in 
other  words,  are  delegated  ad  interim  the  full  powers 
of  the  board. 

Personal  liabilities  of  directors  may  arise  in  four  ways : 

(1)  By  reason  of  neglect  or  wrongdoing  on  their 
part  that  results  in  loss  to  the  company. 

(2)  By  issuing  stock  as  full  paid  that  is  not  actually 
full  paid. 

(3)  By  paying  dividends  out  of  capital. 

(4)  By  doing  other  acts  specifically  forbidden  by  the 
statutes  of  the  state  in  which  the  company  is  incorpo- 
rated. 

These  acts,  it  should  be  observed,  in  the  eyes  of  the 
law  are  wrong  and  fraudulent.  So  long  as  the  direct- 
ors keep  within  the  law,  no  liability  will  attach  to  them 
in  their  capacity  of  directors. 

32.  The  efficiency  of  corporate  organization, — The 
reader  may  now  see  more  clearly  perhaps  why  "central- 
ization of  control"  was  named  in  the  first  chapter  as  one 
of  the  important  advantages  of  corporations.  He  may 
carry  away  a  more  vivid  idea  of  the  whole  arrangement 
if  he  compares  the  corporation  to  a  double  pyramid,  as 
shown  in  this  diagram: 


CORPORATION  FINANCE 


Clerks  and  Iaborers 


The  base  of  one  pyramid  represents  the  body  of  stock- 
holders or  owners  of  the  corporation  who  delegate  their 
rights  as  owners  to  the  directors,  who  in  turn  transfer 
all  active  authority  to  the  president  or  other  chief  execu- 
tive officer,  who  is  at  the  apex  of  that  pyramid.  The 
other  pyramid  represents  the  subordinate  officials  and 
employees  of  the  corporation.  The  chief  executive 
officer  is  also  the  apex  of  this  pyramid  and  transmits 
his  orders  through  the  various  grades  of  subordinates 
to  the  clerks  and  laborers  at  the  base  of  the  pyramid. 
Thus  responsibility  and  authority  conferred  by  the 
stockholders  and  exercised  over  the  employees  are  both 
centered  in  this  chief  executive  officer.  It  is  an  organ- 
ization almost  ideally  adapted,  so  far  as  efficiency  and 
economy  go,  to  the  conditions  of  present-day  industry. 


CHAPTER  IV 

WHERE  AND  HOW  TO  INCORPORATE 

33.  A  corporation  may  he  chartered  in  any  state  and 
do  business  in  other  states, — The  reader  is  probably  well 
aware  that  a  corporation  need  not  necessarily  take  out 
a  charter  in  the  state  in  which  it  transacts  its  principal 
business.  In  fact,  the  great  majority  of  the  large  in- 
dustrial and  railroad  companies  are  incorporated  in  one 
state  and  carry  on  their  operations  in  several  states;  in 
many  cases  none  of  their  permanent  assets  worth  men- 
tioning are  located  in  the  state  of  incorporation. 

This  anomalous  condition  is  made  possible  by  the 
peculiar  character  of  our  American  political  system. 
Each  state  has  the  right  to  create  corporations  and  by 
custom  such  corporations  are  recognized  and  allowed  the 
usual  rights  and  privileges  in  all  other  states.  It  should 
be  noted  at  this  point  that  such  rights  and  privileges 
are  granted  as  a  matter  of  custom  and  of  policy,  or 
of  "comity,"  to  use  the  legal  term,  and  not — as  is  some- 
times stated  even  in  legal  text-books — under  that  clause 
of  the  Constitution  of  the  United  States  which  says 
that  "the  citizens  of  each  state  shall  be  entitled  to  all 
privileges  and  immunities  of  citizens  in  the  several 
states."  A  corporation  is  not  a  citizen,  but  an  artificial 
person  created  by  law,  which  is  an  entirely  different 
thing. 

In  an  early  case  before  the  Supreme  Court  of  the 
United  States,  The  Bank  of  Augusta  vs.  Earle,  the 
right  of  a  corporation  to  make  a  contract  outside  the 

1-4  4.y 


50  CORPORATION  FINANCE 

state  of  its  incorporation  was  brought  into  question. 
The  decision  of  the  Court  upheld  this  right  as  a  legal 
presumption,  but  stated  that  the  right  might  be  with- 
drawn by  any  state  legislature.  The  opinion  written 
by  Chief  Justice  Taney  is  so  important  and  informing 
that  some  of  the  salient  paragraphs  are  quoted  below: 

It  is  very  true  that  a  corporation  can  have  no  legal  existence 
out  of  the  boundaries  of  the  sovereignty  by  which  it  is  created. 
It  exists  only  in  contemplation  of  law,  and  by  force  of  law ;  and 
where  that  law  ceases  to  operate,  and  is  no  longer  obligatory,  the 
corporation  can  have  no  existence.  It  must  dwell  in  the  place 
of  its  creation  and  cannot  migrate  to  another  sovereignty.  But 
although  it  must  live  and  have  its  being  in  that  state  alone,  yet 
it  does  not  by  any  means  follow  that  its  existence  there  will  not 
be  recognized  in  other  places;  and  its  residence  in  one  state 
creates  no  insuperable  objection  to  its  power  of  contracting  in 
another.  It  is  indeed  a  mere  artificial  being,  invisible  and  in- 
tangible; yet  it  is  a  person,  for  certain  purposes  in  contempla- 
tion of  law,  and  has  been  recognized  as  such  by  the  decisions 
of  this  court.  .  .  .  Now,  natural  persons,  through  the  in- 
tervention of  agents,  are  continually  making  contracts  in  coun- 
tries in  which  they  do  not  reside;  and  where  they  are  not  per- 
sonally present  when  the  contract  is  made ;  and  nobody  has  ever 
doubted  the  validity  of  these  agreements.  And  what  greater 
objection  can  there  be  to  the  capacity  of  an  artificial  person, 
by  its  agents,  to  make  a  contract  within  the  scope  of  its  limited 
powers,  in  a  sovereignty  in  which  it  does  not  reside;  provided 
such  contracts  are  permitted  to  be  made  by  them  by  the  laws 
of  the  place.? 

The  corporation  must  no  doubt  show  that  the  law  of  its  crea- 
tion gave  it  authority  to  make  such  contracts,  through  such 
agents.  Yet,  as  in  the  case  of  a  natural  person,  it  is  not  neces- 
sary that  it  should  actually  exist  in  the  sovereignty  in  which  the 
contract  is  made.  It  is  sufficient  that  its  existence  as  an  artificial 
person,  in  the  state  of  its  creation,  is  acknowledged  and  recog- 
nized by  the  law  of  the  nation  where  the  dealing  takes  place; 


WHERE  AND  HOW  TO  INCORPORATE  51 

and  that  it  is  permitted  by  the  laws  of  that  place  to  exercise 
there  the  powers  with  which  it  is  endowed. 

It  is  nothing  more  than  the  admission  of  the  existence  of  an 
artificial  person  created  by  the  law  of  another  state,  and  clothed 
with  the  power  of  making  certain  contracts.  It  is  but  the  usual 
comity  of  recognizing  the  law  of  another  state. 

We  think  it  is  well  settled,  that  by  the  law  of  comity  among 
nations,  a  corporation  created  by  one  sovereignty  is  permitted 
to  make  contracts  in  another,  and  to  sue  in  its  courts ;  and  that 
the  same  law  of  comity  prevails  among  the  several  sovereignties 
of  this  Union.  The  public  and  well-known  and  long-continued 
usages  of  trade ;  the  general  acquiescence  of  the  states ;  the  par- 
ticular legislation  of  some  of  them,  as  well  as  the  legislation  of 
Congress ;  all  concur  in  proving  the  truth  of  this  proposition. 

34.  The  regulation  of  "foreign'  corporations. — In 
the  state  in  which  its  charter  is  granted  a  corporation 
is  called  "domestic" ;  in  other  states  it  is  a  "foreign"  cor- 
poration. This  word  "foreign"  must  not  be  taken  to 
refer  to  corporations  of  other  countries  than  the  United 
States;  such  corporations  are  known  as  "alien." 

Every  state  in  the  Union  regulates  to  a  greater  or 
less  degree  the  business  carried  on  within  its  borders 
by  foreign  corporations.  In  some  states  it  is  necessary 
to  procure  a  license,  which  may  be  obtained  by  deposit- 
ing with  some  official  a  certified  copy  of  the  corpora- 
tion's charter  and  naming  some  agent  on  whom  legal 
papers  may  be  served.  In  other  states  is  is  merely 
required  that  the  foreign  corporation  shall  maintain  an 
office  and  have  an  agent  within  the  state.  Some  states 
restrict  the  power  of  foreign  corporations  to  hold  real 
estate.  These  regulations  are  not  intended  to  apply 
to  corporations  which  merely  solicit  orders  or  execute 
contracts  incidental  to  their  main  business,  but  to  those 
which  are  permanently  established.  • 


52  CORPORATION  FINANCE 

35.  Choosing  the  state  of  incorporation. — Unless 
there  is  some  reason  to  the  contrary,  it  is  generally  much 
better  for  a  corporation  to  get  its  charter  in  the  state 
in  which  its  principal  business  is  located.  This  remark 
applies  particularly  to  small  companies  operating 
wholly  within  one  state.  There  are  several  reasons 
therefor.  One  is  the  fact  that  a  foreign  corporation 
must  usually  pay  incorporation  and  annual  franchise 
taxes  in  the  state  of  incorporation  and  in  addition  a 
license  fee  or  some  other  kind  of  a  tax  in  the  state  in 
which  it  does  business.  Another  reason  is  that  the  courts 
of  each  state  are  inclined  to  treat  domestic  corpora- 
tions with  greater  consideration  than  foreign  corpora- 
tions. A  third  reason  is  that  there  is  a  popular  prej- 
udice, more  or  less  well-founded,  against  those  companies 
which  go  to  other  states  for  their  charter.  Creditors 
and  prospective  buyers  of  the  corporation's  securities 
are  apt  to  ask  embarrassing  questions  as  to  why  the 
corporation  cannot  or  does  not  comply  with  the  legal 
requirements  of  its  own  state.  A  fourth  reason  is  the 
inconvenience  caused  by  the  necessity  of  filing  reports 
and  generally  of  maintaining  a  separate  office  in  the 
state  of  incorporation.  If  the  managers  of  a  small 
local  concern,  therefore,  are  considering  where  to  in- 
corporate, the  answer  will  almost  always  be,  "Get  your 
charter  in  the  state  where  you  expect  to  do  most  of 
your  business." 

The  answer  to  a  similar  question  is  not  so  easy,  how- 
ever, where  the  prospective  corporation  will  be  large, 
or  where  its  business  will  be  widely  scattered  through 
many  states,  or  where  its  managers  have  in  view  some 
purpose  or  purposes  not  favored  by  the  laws  of  the 
state  in  which  its  principal  office  is  to  be  located. 
Neither  is  the  answer  so  easy  even  for  small  local  con- 


WHERE  AND  HOW  TO  INCORPORATE  53 

cerns  in  those  ultra-conservative  states  in  which  the 
corporation  laws  are  unduly  burdensome  or  corporation 
taxes  unduly  expensive.  Under  all  these  circumstances, 
persons  who  are  about  to  form  a  new  corporation,  or 
who  are  thinking  of  giving  up  their  charter  in  one 
state,  will  naturally  look  about  and  compare  the  ad- 
vantages obtainable  under  the  laws  of  the  various  states. 
There  are  great  variations  among  the  states  in  regard 
to  taxes,  liberality  of  corporation  laws  and  treatment  of 
foreign  corporations,  and  the  problem  of  weighing  all 
these  factors  and  picking  out  the  most  economical  and 
advantageous  corporate  home  is  often  very  difficult. 
The  advice  of  a  thoroughly  competent  corporation 
lawyer  in  all  such  cases  is  absolutely  essential.  Never- 
theless, for  his  own  protection,  both  in  forming  and  in 
dealing  with  corporations,  every  business  man  should 
have  a  pretty  accurate  idea  of  the  requirements  and 
privileges  in  all  the  important  states. 

36.  Comparative  charges  in  several  states, — The  first 
and  most  obvious  factor  to  consider  in  selecting  the  state 
of  incorporation  is  the  cost.  This  cost  consists  of 
organization  fees,  annual  taxes  and  counsel  fees.  The 
following  tables  copied  from  a  convenient  manual  by 
Thomas  Conyngton,  of  the  New  York  Bar,  entitled 
"Corporate  Organization,"  will  give  the  reader  an  idea 
of  how  these  expenses  run  in  the  five  states  which  are 
most  commonly  used  for  incorporation  by  companies 
that  expect  to  do  business  in  other  states: 

COMPARATIVE  TABLE  OF  ORGANIZATION  EXPENSES; 


(Including  all 

Filing  and  Incidental  Fees.) 

Capital  Stock 

New 

New 

South 

of  Company. 

Jersey. 

York. 

Delaware.     Maine. 

Dakota. 

$1,000 

$35.00 

$16.00 

$25.00          $27.00 

$13.00 

5,000 

35.00 

17.50 

25.00            27.00 

13.00 

10,000 

35.00 

20.00 

25.00            27.00 

13.00 

54  CORPORATION  FINANCE 


Capital  Stock 

New 

New 

South 

of  Company. 

Jersey 

'.       York. 

Delaware. 

Maine. 

Dakota, 

25,000 

35.00 

2T.50 

25.00 

67.00 

13.00 

50,000 

35.00 

40.00 

25.00 

67.00 

18.00 

100,000 

35.00 

65.00 

25.00 

67.00 

18.00 

500,000 

110.00 

265.00 

65.00 

67.00 

23.00 

1,000,000 

210.00 

515.00 

115.00 

117.00 

28.00 

5,000,000 

1,010.00 

2,515.00 

365.00 

517.00 

43.00 

10,000,000 

2,010.00 

5,015.00 

615.00 

1,017.00 

43.00 

COMPARATIVE  TABLE  OF  ANNUAL  FRANCHISE  TAXES. 

$1,000 

$1.00 

$1.50 

$5.00 

$5.00 

None 

5,000 

5.00 

7.50 

5.00 

5.00 

it 

10,000 

10.00 

15.00 

5.00 

5.00 

u 

25,000 

25.00 

37.50 

5.00 

5.00 

it 

50,000 

50.00 

75.00 

10.00 

5.00 

(( 

100,000 

100.00 

150.00 

.  10.00 

10.00 

(C 

500,000 

500.00 

750.00 

25.00 

50.00 

it 

1,000,000 

1,000.00 

1,500.00 

50.00 

75.00 

« 

5,000,000 

4,000.00 

7,500.00 

150.00 

275.00 

(( 

10,000,000 

4-,250.00 

15,000.00 

275.00 

525.00 

(i 

South  Dakota  and  Delaware  are  fair  examples  of 
what  are  sometimes  called  the  "bargain  counter"  states, 
so  far  as  incorporation  expenses  are  concerned. 
Arizona  also  belongs  in  this  class,  and  West  Virginia 
and  the  District  of  Columbia  might  until  recently  have 
been  included.  As  an  example  of  the  importance  of 
this  feature  when  large  companies  are  formed,  it  has 
been  estimated  that  if  the  United  States  Steel  Corpora- 
tion had  taken  out  its  charter  in  Pennsylvania,  where 
most  of  its  business  is  transacted,  the  organization 
expenses  would  have  been  about  $3,500,000,  whereas  in 
New  Jersey,  where  the  charter  was  actually  obtained,  the 
corresponding  expenses  were  only  about  $220,000.  A 
great  many  companies  which  are  organized  to  exploit 
mines  or  new  inventions  or  other  highly  speculative  en- 
terprises may  without  impropriety  issue  very  large 
amounts  of  stock,  although  the  actual  market  value  of 
their  assets  at  the  time  of  incorporation  may  be  very 


WHERE  AND  HOW  TO  INCORPORATE  55 

small;   in   such  cases   it   is  customary   and   obviously 
economical  to  secure  a  "bargain  counter"  charter. 

In  those  states  where  taxes  and  initial  fees  are  small 
the  necessary  expense  for  legal  assistance  is  apt  to  be  at 
a  minimum,  for  two  reasons:  first,  because  the  state 
legislatures  obviously  are  making  a  bid  for  the  cheap 
incorporation  business  and  will  naturally  make  their 
forms  and  the  necessary  red  tape  of  incorporation  as 
simple  as  possible;  second,  because  in  such  states  incor- 
poration agencies  which  carry  on  their  business  on  a 
wholesale  scale,  are  in  existence,  and  high-priced  legal 
talent  is  hardly  necessary.  In  other  states  competent 
attorneys  should  always  be  secured,  and  their  fees  may 
be  expected  to  range  from  $50  up.  In  this  connection 
it  may  be  well  to  remark  also  that  the  necessary  corpo- 
rate records,  which  are  the  secretary's  minute  book, 
the  stock  certificate  book  and  the  stockholders'  register, 
may  be  obtained  for  from  $10  to  $500  per  set.  One  of 
the  cheaper  sets  is  all  that  is  necessary  for  most  small 
companies.  The  reader  now  has  sufiicient  data  before 
him  to  form  a  rough  estimate  of  the  expense  necessarily 
involved  in  the  process  of  incorporation. 

This  factor  of  initial  cost,  however,  in  the  case  of 
companies  which  expect  permanently  to  carry  on  an 
established  business  is,  after  all,  a  minor  consideration. 
Among  the  other  important  points  to  bear  in  mind  in 
selecting  a  corporate  domicile,  four  stand  out  most 
prominently — the  liberality  of  the  laws,  the  permanence 
of  the  laws,  the  liabilities  attaching  to  stockholders 
and  the  reputation  of  the  state. 

37.  Liberality  of  corporation  laws  in  several  states, — 

^The  chief  respect  in  which  state  laws  differ,  so  far  as 

liberality  is  concerned,  is  in  granting  or  denying  the 

right  to  buy  and  sell  the  securities  of  other  corporations. 


66  CORPORATION  FINANCE 

In  1888  New  Jersey,  first  of  aU  the  states,  enacted  that 
corporations  formed  under  its  laws  might  hold  the  stock 
of  other  corporations.  This  privilege  has  proved  of 
the  greatest  importance  in  the  financial  and  industrial 
development  of  this  country,  as  wiU  be  explained  in  the 
following  chapter.  The  New  Jersey  act  in  this  re- 
spect has  been  followed  by  Delaware,  Maine,  and  New 
York.  The  great  industrial  trusts,  for  this  reason 
primarily,  have  almost  uniformly  obtained  New  Jersey 
charters.  )  The  recent  ruling  in  the  Court  of  Errors 
and  Appeals  of  that  state  limiting  and  defining  the 
right  to  hold  shares  in  other  companies  has  been  men- 
tioned in  Chapter  III. 

VjAnother  feature  in  which  the  various  states  differ 
widely  with  regard  to  liberality  is  the  issuance  of  stock 
for  property.  Most  corporations  as  now  organized 
turn  over  at  least  part  of  their  stock  in  exchange  for 
property,  not  cash.  Some  of  the  states  make  the  esti- 
mate placed  by  the  directors  upon  the  value  of  the  prop- 
erty so  secured  conclusive  unless  fraud  is  clearly  shown. 
Other  states  hedge  this  general  principle  about  with 
irritating  and  usually  unnecessary  restrictions.  Liber- 
ality of  the  state  laws  as  to  other  less  important  points 
will  be  considered  by  careful  incorporators,  but  are  too 
technical  to  be  discussed  here. 

38.  Permanence  of  the  laws, — In  those  states  in 
which  the  general  corporation  statutes  have  existed  for 
some  years  practically  unchanged,  it  is  reasonable  to  ex- 
pect that  they  are  in  fairly  permanent  form.  Moreover, 
in  such  states  the  courts  have  given  a  large  number  of 
decisions  on  vital  points.  Both  the  statutory  law  and 
the  interpretation  of  that  law,  therefore,  may  be  con- 
sidered well  settled.  This  is  a  matter  of  prime  impor- 
tance to  large  corporations,  which  may  expect,  from  the 


WHERE  AND  HOW  TO  INCORPORATE  57 

very  extent  of  their  business,  to  be  involved  in  more  or 
less  litigation.  They  want  to  know  where  they  stand 
at  all  times  and  do  not  care  to  be  confronted  with  sudden 
legislative  enactments  or  with  unexpected  court  de- 
cisions. In  this  respect  New  Jersey  is  particularly 
favored  and  this  furnishes  an  additional  reason  why  the 
large  corporations  tend  so  strongly  to  incorporate  in 
that  state. 

The  liabilities  imposed  upon  stockholders  have  already 
been  treated  in  the  preceding  chapter.  Massachusetts, 
New  York,  California  and  Minnesota,  as  there  noted, 
impose  certain  Uabilities  additional  to  the  usual  liability 
on  capital  stock.  In  the  fkst  two  states  these  liabilities 
are  not  apt  to  prove  a  serious  matter.  Corporations, 
however,  generally  avoid  California  and  Minnesota.^ 

39.  Reputations  of  various  states. — The  reputation 
of  the  state  of  incorporation  may  have  considerable 
effect  on  the  sale  of  corporate  securities.  It  is  so  well- 
known,  for  instance,  that  the  laws  of  South  Dakota 
and  Arizona  are  lax  that  investors  look  with  distrust 
on  any  corporation  which  operates  under  one  of  their 
charters.  This  statement,  although  to  a  much  less  de- 
gree, applies  to  Delaware  and  to  Maine.  New  Jersey 
is  so  popular  a  state  for  incorporation  that  its  provisions 
are  well-known  and  its  reputation  is  reasonably  good. 
West  Virginia  and  the  District  of  Columbia  do  not 
rank  nearly  so  well,  on  account  of  their  record,  although 
the  District  of  Columbia  law  in  1905,  on  the  recom- 
mendation of  President  Roosevelt,  was  altered  and 
improved  and  the  West  Virginia  law  also  has  been 
changed.  Connecticut,  Massachusetts,  Pennsylvania 
and  Illinois  have  reasonably — Massachusetts  perhaps 
unreasonably — strict  requirements,  and  all  as^  states 
of  incorporation  are  in  good  repute,     Among  aU  the 


58  CORPORATION  FINANCE 

states.  New  York,  under  its  "Business  Corporations 
Law,"  as  amended  in  recent  years,  perhaps  best  com- 
bines the  advantages  of  liberality  and  of  high  repute. 
Its  laws,  however,  have  not  been  so  thoroughly  tested 
and  settled  by  the  courts  as  the  corresponding  laws  of 
New  Jersey. 

40.  Comparative  summary  of  the  advantages  and 
disadvantages  of  the  important  states. — For  the  benefit 
of  readers  who  may  desire  to  form  a  corporation  or  who 
may  have  occasion  to  consider  the  advisabihty  of  buying 
stock  of  a  company  incorporated  in  some  other  state 
than  the  one  in  which  it  does  business  we  give  below  a 
brief  summary  of  the  advantages  and  disadvantages  of 
several  states: 

ARIZONA. 

Advantages: 

1.  Stock  may  be  issued  for  money,  property,  or  services. 
The  fact  that  it  can  be  issued  for  services  may  be  an  important 
advantage. 

2.  Directors'  meetings  may  be  held  outside  of  the  territory. 

3.  The  organization  fee  is  very  small.  Moreover,  there  is  no 
annual  franchise  tax. 

Disadvantages: 

1.  Stockholders'  meetings  must  be  held  within  the  territory. 

2.  The  corporation  laws  are  unadjudicated. 

CONNECTICUT. 

Many  promoters  do  not  care  to  incorporate  in  Connecticut  as 
they  imagine  that  the  advantages  are  not  very  great.  As  a 
matter  of  fact,  after  a  thorough  analysis  we  find  that  the  high 
organization  fee  is  the  chief  disadvantage. 

Advantages: 

1.  Stock  may  be  paid  for  in  either  cash  or  property.  The 
judgment  of  the  directors  ig  final  with  regard  to  the  value  of 


WHERE  AND  HOW  TO  INCORPORATE  59 

the   property    for   which    stock   is   issued,    except   in    case    of 
fraud. 

2.  Incorporators  may  be  non-resident. 

3.  There  is  no  annual  franchise  tax. 

4.  Corporations  may  hold  stock  in  other  corporations. 

Disadvantages : 

1.  Stockholders'  meetings  must  be  held  within  the  state. 
There  is  no  provision  requiring  the  meetings  of  the  directors  to 
be  held  within  the  state,  but  this  may  be  inferred. 

2.  There  is  an  inheritance  tax  on  the  stock. 

3.  The  organization  fees  are  comparatively  high,  from  $25  to 
$2,510. 

DELAWARE. 

Advantages: 

1.  Stockholders'  and  directors'  meetings  may  be  held  outside 
of  the  state,  if  the  by-laws  so  provide. 

2.  Stock  may  be  issued  for  cash,  property  or  services. 

3.  Incorporators  may  be  non-resident. 

4.  Corporations  may  hold  stock  in  other  corporations. 

5.  Provision  may  be  made  whereby  bondholders  will  be  per- 
mitted to  vote.  This  provision  makes  a  good  market  for  bonds 
because  bondholders  will  be  assured  that  they  will  have  a  voice 
in  the  management  of  the  corporation. 

6.  Organization  fees  are  not  very  large,  ranging  from  $20  to 
$765,  including  filing  fees. 

Disadvantages : 

1.  One  of  the  directors  must  live  in  Delaware. 

2.  There  is  an  inheritance  tax  on  stock,  applying  both  to  resi- 
dents and  to  non-residents. 

3.  There  is  an  annual  franchise  tax. 

DISTRICT  OF   COLUMBIA. 

Advantages: 

1.  Very  small  cost  of  incorporation,  probably  not  exceeding 
$10. 

2.  No  franchise  or  inheritance  tax.  • 


60  CORPORATION  FINANCE 

Disadvantages : 

1.  A  majority  of  the  trustees,  (the  term  trustee  corresponds 
to  the  term  director)  must  live  in  the  District. 

2,  Stock  cannot  be  issued  for  services,  only  for  property  or 
cash. 

2.  10  per  cent  of  capital  stock  must  be  paid  in  before  begin- 
ning business.  New  York  requires  50  per  cent  paid  in  before 
the  end  of  the  first  year,  but  business  can  be  carried  on  in  the 
meantime.  Here,  no  business  can  be  done  in  the  name  of  the 
corporation  till  10  per  cent  is  fully  paid  iii?N> 

4.  An  annual  report  of  the  corporation  must  be  filed  and 
published.  This  report  must  include  amount  of  capital  stock 
authorized,  amount  paid  in  and  amount  of  existing  debts. 

5.  The  corporation  cannot  own  stock  in  other  corporations. 

6.  Corporation  laws  are  unadjudicated. 

MAINE. 

Advantages: 

1.  Stock  may  be  issued  for  property,  cash  or  services.  The 
judgment  of  the  directors  is  conclusive  as  to  value  of  the  prop- 
erty— always  provided  there  is  no  evidence  of  fraud. 

2.  Incorporators  and  directors  may  be  non-resident. 

3.  Directors'  meetings  may  be  held  outside  of  the  state. 

4.  The  corporation  may  acquire  stock  in  other  corporations. 

5.  Low  organization  fees,  ranging  from  $10  to  $517  for  a 
$5,000,000  corporation. 

Disadvantages : 

1.  Stockholders'  meetings  must  be  held  within  the  state. 

2.  There  is  both  an  inheritance  and  an  annual  franchise  tax ; 
the  latter,  however,  is  very  small. 

MASSACHUSETTS. 

Advantages: 

1.  Incorporators  and  directors  may  be  non-resident. 

2.  Directors'  meetings  may  be  held  outside  of  the  state. 

3.  Stock  may  be  issued  for  cash,  property  or  services. 


WHERE  AND  HOW  TO  INCORPORATE  61 

Disadvantages : 

1.  Stockholders'  meetings  must  be  held  within  the  state. 

2.  The  corporation  cannot  hold  stock  in  other  corporations. 

3.  A  detailed  annual  report  must  be  rendered  to  the  state  au- 
thorities. 

4.  There  is  an  inheritance  tax. 

5.  The  organization  fee  varies  from  $10  for  a  $10,000  cor- 
poration to  $1,200  for  a  $5,000,000  corporation;  there  is  no 
filing  fee. 

NEVADA. 

Advantages: 

1.  Incorporators  and  directors  may  be  non-resident. 

2.  Stockholders'  and  directors'  meetings  may  be  held  outside 
of  the  state. 

3.  Stock  may  be  issued  for  cash,  property  or  services.  The 
judgment  of  the  directors  is  conclusive  as  to  value  of  prop- 
erty, providing  there  is  no  evidence  of  fraud. 

4.  Action  of  the  majority  of  the  stockholders  or  directors 
may  be  valid  without  regular  meeting;  that  is,  there  may  be 
an  informal  meeting  held,  without  any  notice  whatsoever  being 
given. 

5.  Bondholders  may  be  given  the  right  to  vote. 

6.  Cumulative  voting  is  allowed. 

7.  No  annual  franchise  tax. 

8.  The  organization  fee  is  comparatively  low,  ranging  from 
$15  to  $700 ;  there  are  no  filing  fees  whatever. 

Disadvantages : 

1.  In  some  cases  an  annual  report  must  be  prepared  for  the 
state  authorities. 

2.  The  state's  reputation  as  a  corporate  home  is  not  of  the 
best. 

NEW   JERSEY. 

Advantages: 

1.  Corporations  may  hold  stock  in  other  corporations.  New 
Jersey  was  the  first  state  to  authorize  the  formation  of  holding 
companies.  • 


62  CORPORATION  FINANCE 

2.  Incorporators  may  be  non-resident. 

3.  Stock  may  be  issued  for  property  or  cash.  Judgment  of 
the  directors  is  conclusive  as  to  value  of  property.  No  pro- 
vision is  made  for  this  judgment  being  set  aside  upon  evidence 
of  fraud. 

4.  Directors'  meetings  may  be  held  outside  of  the  state,  if 
by-laws  so  provide. 

5.  Cumulative  voting  is  permitted. 

6.  A  voting  trust  may  be  created. 

7.  Laws  are  all  well  adjudicated. 

Disadvantages : 

1.  Stockholders'  meetings  must  be  held  within  the  state. 

2.  One  of  the  directors  must  live  in  the  state. 

3.  There  is  an  annual  franchise  tax ;  also  an  inheritance  tax, 
but  this  does  not  apply  to  non-residents.  Fees  are  from  $25  to 
$1,000;  filing  fee  $10. 

NEW  yORK. 

Advantages: 

1.  Stock  may  be  issued  for  cash,  property,  or  labor.  Labor 
must  be  distinguished  from  "services"  though  there  is  no  de- 
cision explaining  the  exact  difference.  The  judgment  of  the 
directors  is  conclusive  as  to  value  of  property,  provided  there  is 
no  evidence  of  fraud. 

2.  Directors'  meetings  may  be  held  outside  of  the  state. 

3.  Corporations  may  hold  and  control  the  stock  of  other  cor- 
porations. 

4.  Cumulative  voting  is  permitted. 

5.  A  voting  trust  may  be  created,  limited,  however,  to  five 
years. 

Disadvantages : 

1.  Stockholders'  meetings  must  be  held  within  the  state. 

2.  One  incorporator  and  one  director  must  reside  within  the 
state. 

3.  One-half  of  the  capital  stock  must  be  paid  in  within  a  year 
from  incorporation. 

4.  Detailed  books  and  accounts  of  the  business  are  required. 


WHERE  AND  HOW  TO  INCORPORATE  63 

41.  Agreements  prior  to  incorporation. — Sometimes 
a  corporation  is  formed  practically  by  and  for  an  in- 
dividual acting  alone,  who  expects  to  take  all  the  stock 
except  what  is  necessary  to  qualify  dummy  directors 
and  either  hold  it  permanently  or  dispose  of  it  whenever 
an  opportunity  arises  later.  Frequently,  also,  it  hap- 
pens that  a  corporation  is  organized  to  take  over  the 
business  of  a  pre-existing  partnership  and  the  partners 
have  come  to  an  informal  understanding  as  to  how  much 
stock  shall  be  issued  to  each  one.  Under  such  circum- 
stances, of  course,  no  formal  agreements  previous  to 
incorporation  are  necessary. 

In  many  instances,  however,  corporations  are  formed 
by  the  harmonious  action  of  a  number  of  men  who 
mutually  agree  as  to  the  purposes,  capitalization  and 
other  essential  features  of  the  new  corporation  and  who 
each  subscribe  for  a  certain  amount  of  stock.  In  such 
cases  it  is  customary  to  draw  up  what  is  known  as  a 
"subscription  contract"  and  to  leave  space  at  the  bottom 
of  this  contract  for  each  subscriber  to  write  his  name 
and  fill  in  the  number  of  shares  that  he  agrees  to  take. 
The  subscription  contract  should  state  among  other 
things  the  par  value  of  each  share  of  stock,  the  total 
number  of  shares  to  be  issued  and  the  total  number  to 
be  subscribed,  in  order  to  make  the  contract  binding. 
Usually  the  subscription  list  is  accompanied  by  a  pros- 
pectus (described  in  Chapter  XXIII)  which  more  fully 
states  what  the  corporation  is  expected  to  accomplish. 
It  should  be  noted  that  the  subscription  contract  may  be 
made  immediately  binding  by  having  the  amount  of 
the  subscription  payable  to  certain  specified  trustees; 
or  if  not  immediately  binding,  it  will  become  binding  as 
soon  as  the  proposed  corporation  is  properly  organized 
and  prepared  to  handle  funds.  • 


64  CORPORATION  FINANCE 

The  remaining  step  in  incorporation  is  very  simple 
and  has  already  been  touched  upon  in  Chapter  I.  It 
consists  of  drawing  up  a  charter  in  proper  legal  form, 
filing  it  with  the  secretary  of  state  or  such  other 
official  as  is  designated  by  the  laws  of  the  state  in  which 
the  charter  is  to  be  obtained,  and  receiving  notice  of 
his  acceptance  thereof. 

42.  The  wide  range  of  choice  in  incorporation, — If 
the  reader  has  acquired  by  the  reading  of  this  chapter 
a  clear  conception  of  the  freedom  and  liberality  of 
corporation  laws  and  of  the  ease  with  which  almost  any 
legitimate  business  may  be  put  into  the  form  of  the  cor- 
poration, the  main  purpose  of  the  chapter  will  have  been 
fulfilled.  The  advantages  of  the  corporate  form  for 
almost  all  kinds  of  business  were  pointed  out  in  the  first 
chapter.  One  of  the  chief  advantages  named  was 
flexibility,  by  which  was  meant  the  ease  with  which  the 
corporate  form  could  be  adapted  to  small  or  to  large 
enterprises.  Now  we  are  in  a  position  to  expand  still 
further  the  meaning  of  that  word  "flexibility"  in  con- 
nection with  corporations  and  to  say  that  it  means  also 
the  ease  with  which  the  corporate  form  may  be  adjusted 
to  any  sort  of  a  business  need.  If  the  incorporators 
cannot  find  in  one  state  the  authority  or  the  cheapness 
that  they  desire,  they  may  pick  out  some  other  state  in 
which  those  qualities  are  prominent  in  the  general  cor- 
poration law.  If  the  incorporators  desire  permanence 
and  legal  stability  above  all  things,  they  may  go  to  still 
another  state.  The  range  of  choice  is  wide.  It  takes 
only  a  little  effort  and  ingenuity  for  a  capable  lawyer 
to  fit  out  a  business  enterprise  with  the  exact  corporate 
powers  and  organization  that  will  prove  most  advan- 
tageous. 


CHAPTER  Yi 

CORPORATE  STOCK 

43.  Stock  certificates  not  fully  negotiable. — As  has 
already  been  saidfcorporate  stock  is  not  a  tangible  thing ; 
it  is  simply  a  right  to  share  under  certain  limitations  in 
the  management,  the  assets  and  the  earnings  of  the 
issuing  corporation.  Stock  is  represented  by  certifi- 
cates, which  are  in  the  possession  of  the  owners.  These 
certificates,  however,  it  must  not  be  forgotten,  are  merely 
evidence,  not  proof,  of  the  ownership  of  stock.  Actual 
ownership  is  proved  by  reference  to  the  books  of  the 
company  in  which  the  names  of  the  stockholders  and 
the  number  of  shares  held  by  each  one  are  entered. 
Certificates  of  stock  are  not,  therefore,  strictly  speaking, 
negotiable  instruments,  but  quasi-negotiable^a  term 
which  the  reader  will  find  defined  in  the  volume  on 
Commercial  Law. 

The  question  as  to  whether  stock  certificates  ought  to 
be  made  negotiable  or  not  has  been  much  agitated,  es- 
pecially among  lawyers.  A  committee  of  the  Commis- 
sion on  Uniform  State  La;ws,  which  is  a  body  of  lawyers 
appointed  by  the  governors  of  forty-one  states,  issued 
a  report  in  March,  1909,  strongly  advocating  amend- 
ments to  existing  laws  which  would  make  transfer  of 
ownership  of  corporate  stock  complete  on  delivery  of 
endorsed  certificates  of  stock  without  waiting  for  the 
formal  transfer  on  the  books  of  the  corporation;  in 
other  words,  the  proposed  amendments  would  make 
certificates  of  stock  true  negotiable  instruments.  The 
1-5  65 


66  CORPORATION  FINANCE 

important  sections  of  the  text  of  the  proposed  amend- 
ments are  as  follows: 

Section  1.  Title  to  a  certificate  and  to  the  shares  represented 
thereby  may  be  transferred, 

(a)  By  the  delivery  of  the  certificate,  if  indorsed  either 
in  blank  or  to  be  a  specified  person  appearing  by  the  certificate 
to  be  the  owner  of  the  shares  represented  thereby. 

(b)  By  delivery  of  the  certificate  with  a  written  assign- 
ment thereon,  or  a  power  of  attorney  to  sell,  assign,  or  transfer 
the  certificate  of  the  shares  represented  thereby  signed  by  the 
person  appearing  by  the  certificate  to  be  the  owner  of  the  shares 
represented  thereby.  Such  assignment  or  power  of  attorney 
may  be  either  in  blank  or  to  a  specified  person. 

The  provisions  of  this  section  shall  be  applicable  although 
the  charter  or  articles  of  incorporation  or  code  of  regulations 
or  by-laws  of  the  corporation,  issuing  the  certificate  and  the 
certificate  itself  provide  that  the  shares  represented  thereby  shall 
be  transferable  only  on  the  books  of  the  corporation  or  shall  be 
registered  by  a  registrar  or  transferred  by  a  transfer  agent. 

Section  17.  Nothing  in  this  act  shall  be  construed  as  for- 
bidding a  corporation  to  treat  as  owner  in  every  way  the  person 
who  may  be  registered  on  its  books  as  the  owner  of  shares.  '\ 

In  an  editorial  in  The  Journal  of  Accountancy,  the 
writer  said  as  to  this  proposed  amendment : 

Accountants,,  as  well  as  lawyers  and  business  men,  have  a  di- 
rect interest  in  this  proposition.  If  it  is  adopted  by  the  states 
in  which  numerous  corporate  charters  are  granted,  the  effects 
will  be  felt  in  many  different  forms.  Indeed,  it  is  doubtful, 
judging  from  their  explanatory  notes,  whether  the  commission- 
ers realize  what  an  extensive  reform  they  are  proposing.  At 
first  glance,  to  be  sure,  it  does  not  appear  that  any  considerable 
revision  of  present  practice  is  intended;  yet  the  act  plainly 
points  toward  passing  the  rights  and  privileges  of  stockholders 
along  with  transfers  of  stock  certificates. 

[The  change  would  no  doubt  facilitate  somewhat  the  purchase 


CORPORATE  STOCK  6T 

and  sale  of  stock  by  removing  the  technical  requirement  that 
transfers  must  be  made  on  the  books  of  the  corporation.  It 
would  enable  the  stock  exchange  brokers  to  carry  on  their  busi- 
ness more  easily  and  more  smoothly.  It  would  make  stock  cer-' 
tificates  more  acceptable  to  banks  as  collateral  for  loans.  These 
are  the  strongest  arguments  in  favor  of  the  act.  ^^ 

On  the  other  side  of  the  question,  it  should  be  remarked  that 
making  certificates  of  stock  fully  negotiable  subjects  them  to 
increased  danger  of  forgery,  theft  and  loss.  Many  people,  no 
doubt,  would  prefer  the  comparative  safety  of  the  present  sys- 
tem, just  as  many  investors,  when  a  choice  is  offered,  take  regis- 
tered rather  than  coupon  bonds.  This  is  a  point  of  considerable 
importance.  A  far  stronger  argument  against  the  proposed 
measure,  however,  is  that  it  would  destroy  the  value  of  a  cor- 
poration's record  of  its  stockholders  and  would  thereby  foster 
fraud.  Accountants  are  only  too  familiar  with  cases  in  which 
corporations  are  organized  simply  for  the  purpose  of  transfer- 
ring property  from  one  hand  to  another  in  such  a  manner  as  to 
conceal  profits  or  to  swindle  creditors.  Under  the  present  ar- 
rangement it  is  generally  possible,  if  fraud  is  suspected,  to  get 
access  to  the  stockholders'  ledger  and  to  learn  who  are  the  owners 
of  the  corporation.  If  a  connection  between  the  former  owners 
of  the  transferred  property  and  the  stockholders  of  the  corpora- 
tion can  be  proven,  a  case  of  fraud  may  be  made  out.  Under 
the  proposed  arrangement  it  would  be  impossible  to  discover  the 
true  owners  of  such  a  corporation.  The  stockholders'  ledger, 
indeed,  might  be  kept,  but  it  would  be  of  small  value.  The  cer- 
tificates of  stock,  and  consequently  the  ownership  of  the  cor- 
poration, might  change  hands  a  half  dozen  times  without  ap- 
pearing on  the  corporation's  books.  1  Numerous  similar  cases 
will  occur  to  any  accountant. 

We  do  not  wish  to  go  on  record  as  absolutely  opposed  to  this 
act.  We  have  no  doubt  that  it  would  be  a  convenience  to  cor- 
poration officials,  bankers  and  business  men  generally  if  stock 
certificates  were  made  fully  negotiable.  We  would  emphasize 
the  fact,  however,  that  this  provision  would  also  prove  a  great 
convenience  where  fraud  or  manipulation  is  intended.     It  would 


68  CORPORATION  FINANCE 

make  secrecy  as  to  corporate  ownership  even  easier  than  it  is 
now  and  would  tend  to  lessen  the  responsibility  that  ought  to 
attach  to  the  stockholders  of  corporations.  We  think  these  evils 
important  enough  to  outweigh  the  advantages  that  have  been 
named.  For  that  reason  we  suggest  that  the  law  with  regard  to 
transfers  of  stock  ought  to  be  left  unchanged  until  further  pro- 
vision has  been  made  for  publicity  of  corporate  accounts  and  for 
detection  and  punishment  of  the  frauds  which  the  corporate 
form  already  too  much  favors.^ 

44.  Par  vs,  market  value  of  stock. — Each  share  of 
stock  in  practically  every  case  has  a  nominal  money 
value.  The  most  common  nominal  value  of  each  share 
is  $100;  other  nominal  values  conmionly  used  are  $50, 
$25,  $10  and  $1.  This  nominal  money  value  of  each 
share  is  sometimes  called  the  "par  value."  To  the  un- 
initiated the  par  value  of  stock  often  seems  quite  an 
important  matter.  They  are  apt  to  regard  it  as  being 
of  much  the  same  character  as  the  face  value,  say,  of  a 
promissory  note.  A  little  reflection,  however,  will 
readily  convince  anyone  that  there  is  no  close  analogy 
between  the  par  value  of  a  share  of  stock  and  the  face 
value  of  a  note,  and  that  the  par  value  of  a  share  throws 
no  light  whatever  on  the  actual  value  of  that  share. 

To  make  this  proposition  clear,  let  us  suppose  that 
three  oil  wells  are  discovered  by  three  diiFerent  individ- 
uals, the  three  wells  being  practically  identical  in 
location,  quality  of  oil  produced,  amount  of  flow,  per- 
manence, cost  of  operation,  access  to  markets,  and  other 
essential  attributes.  Each  of  the  owners,  we  will  say, 
interests  some  friends  and  outsiders  and  organizes  a 
corporation  to  work  his  well.  One  owner  is  extremely 
conservative  and  therefore  has  his  corporation  issue  only 
1000  shares  of  a  par  value  of  $1  per  share;  the  second 

1  The  Journal  of  Accountancy,  March,  1909. 


CORPORATE  STOCK  69 

owner,  being  somewhat  more  sanguine,  thinks  his  well 
is  worth  more  and,  therefore,  has  his  corporation  issue 
1000  shares,  each  of  a  par  value  of  $10;  the  third  owner 
is  blessed  with  a  vivid  imagination  which  leads  him  to 
have  his  corporation  issue  1000  shares,  each  of  a  par 
value  of  $100.  Now  what  will  be  the  actual  value  of  a 
single  share  in  each  of  these  companies?  Obviously 
each  share  entitles  the  owner  to  one  one-thousandth  of 
the  assets  and  earnings  of  the  well.  As  the  wells,  ac- 
cording to  our  supposition,  are  equally  profitable,  there 
will  be  no  difference  whatever  between  the  three  shares 
so  far  as  their  actual  values  are  concerned. 

Any  number  of  further  examples,  drawn  from  ex- 
perience, might  be  given  to  illustrate  this  truth.  In 
fact,  a  simple  inspection  of  the  prices  for  stock  bought 
and  sold  on  the  various  stock  exchanges  of  the  country 
is  sufficiently  convincing.  Most  of  the  shares  of  stock 
there  traded  in  have  par  values  of  $100;  their  market 
values  will  be  found  to  range  between  next  to  nothing 
and  $600  or  $700 — sometimes  even  more  for  bank  stock. 

The  fact,  then,  that  a  certain  share  of  stock  has  a 
nominal  value  is  of  small  importance.  Its  practically 
valuable  attribute  is  its  right  to  a  certain  share  in  the 
corporation's  assets  and  earnings.  How  much  is  that 
share  to  be?  That  question  may  be  answered  simply 
by  knowing  how  many  shares  of  stock  are  outstanding. 
If  a  corporation's  assets  are  worth  $1,000,000  and  there 
are  1000  shares  in  the  hands  of  stockholders,  we  know 
at  once  that  the  true  value  of  each  share  is  $1000  with- 
out reference  to  its  par  value. 

This  leads  us  to  a  question  which  was  brought  up 
several  years  ago  by  a  prominent  corporation  lawyer 
and  has  been  much  discussed.  Why  not  eliminate  these 
useless  par  values  and  make  each  share  in  form  as  it  is 


70 


CORPORATION  FINANCE 


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CORPORATE  STOCK  71 

in  practice  simply  a  right  to  a  certain  percentage  of  the 
assets  and  earnings  of  the  issuing  corporation?  The 
form  of  a  certificate  of  stock  under  the  present  system  is 
given  on  page  70.  The  question  before  us  is  whether  it 
would  not  be  better  to  make  the  second  line  of  the  face  of 
the  certificate  read  instead  of  "Capital  Stock  $1,000,- 
000,"  "Number  of  shares  10,000,"  and  to  eliminate  the 
last  line,  "Shares  $100  each,"  altogether.  Logically 
there  could  be  no  objection  to  the  proposal;  each  share 
would  be  just  as  valuable — no  more  and  no  less — after 
the  change  as  before.  The  chief  advantage  gained 
would  be  that  misconceptions  based  on  the  idea  that 
par  value  and  actual  value  in  some  way  correspond 
would  no  longer  be  possible. 

Although  this  reform  would  be  desirable,  it  is  not 
very  seriously  advocated  and  probably  will  never  be 
adopted  simply  because  the  custom  of  assigning  a 
nominal  money  value  to  each  share  has  become  well 
established  and  would  be  very  difficult  to  eradicate. 
The  same  object  will  be  attained  in  time,  as  people  be- 
come more  familiar  with  corporation  practice,  by  the 
general  recognition  of  the  obvious  fact  that  par  value 
and  actual  value  of  shares  of  stock  need  not  correspond. ; 
This  question  will  be  somewhat  further  discussed  in 
Chapter  VII  in  connection  with  capitalization. 

45.  Nature  of  preferred  stock. — In  most  corpora- 
tions all  the  stock  is  of  one  class  and  each  share  has  an 
equal  right  to  its  proportion  of  the  assets  and  earnings. 
Such  stock  is  called  "common"  because  no  share  has  any 
privileges  which  do  not  attach  to  all  the  other  shares. 
In  general,  common  stock  may  be  defined  as  stock  which 
does  not  possess  any  special  or  peculiar  rights. 

Other  corporations,  however,  set  aside  certain  amounts 
of  stock  in  a  separate  class  and  grant  to  this  class  spe- 


73  CORPORATION  FINANCE 

ciiic  privileges.  Such  stock  is  called  preferred.  The 
usual  preference  consists  in  giving  a  fixed  dividend 
to  the  stock  preferred  before  any  payment  whatever  is 
made  to  the  common  stock.  This  dividend  may  be 
"cumulative";  that  is,  if  profits  are  not  enough  to  pay 
it  in  full  in  one  or  more  years,  the  unpaid  portion  re- 
mains as  a  claim  against  earnings  that  must  be  settled 
before  any  payment  is  made  to  the  common  stock.  Or 
it  may  be  "non-cumulative";  that  is,  if  profits  in  any 
year,  including  usually  the  accumulated  profits  of  pre- 
ceding years,  are  insufficient  to  cover  the  preferred  stock 
dividend,  the  unpaid  portion  is  wholly  lost  to  the  pre- 
ferred stockholders,  no  matter  how  large  the  earnings 
in  succeeding  years  may  be.  Let  it  be  kept  clearly  in 
mind,  however,  that  preference  as  to  dividends  is  merely 
the  usual,  not  the  universal,  privilege  given  to  preferred 
stock.  When  the  single  statement  that  stock  is  "pre- 
ferred" is  made,  it  is  necessary  to  consult  the  charter  and 
by-laws  of  the  corporation  in  order  to  be  sure  as  to  the 
exact  nature  of  the  preference. 

The  stock  may  be  preferred  as  to  assets,  as  well  as 
dividends,  or  as  to  both.  Furthermore,  cumulative 
preferred  stock  may  get  a  fixed  dividend,  and  no  more, 
which  is  the  customary  arrangement;  it  may  get  a  fixed 
dividend  and  then,  after  the  common  stock  has  secured 
a  fixed  dividend,  all  the  rest  of  the  earnings  may  be 
divided  equally  between  the  two  stocks,  which  is  the 
arrangement  presumed  by  law  unless  an  expressed  stip- 
ulation to  the  contrary  is  contained  in  either  the  charter 
or  by-laws ;  or  it  may  get  a  fixed  dividend  and  the  com- 
mon stock  a  fixed  dividend  and  all  the  rest  of  the  earn- 
ings may  then  go  to  the  preferred  stock,  which  is  a 
very  unusual  arrangement. 

Preferred  stock  had  its  origin  in  railroad  reorganiza- 


CORPORATE  STOCK  79 

tions.  In  reorganization  after  bankruptcy  it  is 
necessary  to  cut  down  the  claims  of  the  various  bond 
issues  outstanding  in  order  to  put  the  reorganized  cor- 
poration in  a  reasonably  safe  condition.  The  interest 
on  the  first  mortgage  bonds  is  usually  scaled;  some  of 
the  junior  issues  are  perhaps  turned  into  income  bonds; 
and  in  the  seventies  some  bright  mind  conceived  the  idea 
of  changing  the  inferior  bond  issues  into  preferred 
stock.  This  process  will  be  explained  much  more  fully 
in  our  discussion  of  bankruptcy  and  reorganization. 

46.  Uses  of  preferred  stock, — Although  preferred 
stock  was  originally  the  offspring  of  receiverships,  it 
proved  to  be  such  a  useful  instrument  for  some  purposes 
that  it  has  been  retained  and  is  now  much  used,  especially 
by  industrial  companies.  The  railroad  companies,  for 
reasons  that  will  be  later  discussed,  are  gradually  giving 
it  up. 

Apart  from  its  usefulness  already  alluded  to  in  cases 
of  reorganization,  preferred  stock  serves  four  other 
purposes.  First,  it  may  be  a  convenient  means  of 
iseparating  a  company's  stock  into  diiFerent  voting 
classes.  Sometimes  the  preferred  stock  has  no  vote  at 
all ;  sometimes  it  elects  a  limited  number  of  stockholders. 
In  either  case  the  owners  of  the  majority  of  the  common 
stock  may  elect  a  majority  of  the  board  of  directors. 
Therefore,  a  much  smaller  interest  will  control  the 
business  than  would  be  necessary  if  all  the  stock  issued 
voted  alike. 

Second,  preferred  stock  is  often  very  useful  in  form- 
ing industrial  consolidations.  As  we  shall  see  in  the 
study  of  these  consolidations,  they  are  usually  capitalized 
for  a  great  deal  more  than  the  combined  capitalization 
of  their  subsidiary  companies.  Ordinarily  the  extra 
capitalization,  which  represents  prospects,  takes  the  form 


74  CORPORATION  FINANCE 

of  common  stock,  and  the  present  value  of  the  plants 
and  businesses  absorbed  is  represented  by  bonds  and 
preferred  stock.  The  subsidiary  company  stockholders 
are  much  more  inclined  to  exchange  their  common 
stock  for  preferred  stock  in  the  consolidation  than  they 
would  be  to  exchange  for  conmion  stock.  If  the 
subsidiary  businesses  have  been  successful  and  profitable 
it  is  reasonable  to  expect  that  dividends  on  the  preferred 
stock  can  be  paid,  whereas  nobody  can  foresee  whether 
cormnon  dividends  will  be  paid  or  not. 

The  third  purpose  of  preferred  stock  is  to  facilitate  the 
incorporation  of  a  business  which  has  been  conducted  as 
a  partnership.  In  a  partnership  each  partner  has  as 
much  say  with  regard  to  affairs  as  any  other  partner, 
irrespective  of  the  extent  of  his  interest.  It  is  true  that 
in  practice  the  senior  partner  usually  controls,  but  in  law 
they  are  all  on  the  same  footing.  They  may  desire  to 
preserve  the  same  arrangement  in  the  corporation,  in 
which  case  they  may  create  a  non-voting  common  stock 
and  assign  that  stock  to  each  partner  in  proportion  to  his 
interest  in  the  partnership  and  in  addition  may  make  a 
voting  preferred  stock,  of  which  each  partner  receives 
an  equal  amount.  In  this  case  it  is  possible  that  the  so- 
called  preferred  stock  may  have  preference  in  nothing 
except  voting  power. 

Fourth,  preferred  stock  obviously  may  attract  con- 
servative investors  who  would  not  care  to  buy  the  more 
speculative  common  stock  of  a  corporation.  Preferred 
stock,  in  point  of  security,  ranks  between  the  lower 
grades  of  bonds,  which  are  described  in  succeeding  chap- 
ters, and  common  stock.  The  preferred  stock  of  indus- 
trial corporations,  on  account  of  their  fluctuating  earn- 
ings, usually  sells  at  much  better  prices  than  the  common 
stock  of  the  same  corporations,  even  though  the  common 


CORPORATE  STOCK  75 

stock  may  receive  on  the  average  as  large  or  larger  divi- 
dends. 

Sometimes  a  certain  amount  of  stock  will  be  set  aside 
at  the  organization  of  a  corporation  and  given  voting 
power,  which  right  is  denied  to  all  the  other  stock.  In 
such  a  case  the  corporation  has  in  existence  two  classes  of 
stock,  "voting"  and  "non-voting."  This  is  not  at  all  a 
common  arrangement  and  is  rarely,  if  ever,  adopted  ex- 
cept when  a  partnership  business  is  put  into  the  corpo- 
rate form.  It  amounts  to  the  same  thing  as  creating 
preferred  stock  with  the  preference  confined  to  the  privi- 
lege of  voting. 

47.  Cumulative  t;o^m^.-r-Originally  the  universal  cus- 
tom as  to  the  voting  power  of  corporate  stock  was  to  give 
one  vote  to  each  share.  The  custom  is  still  general,  at 
least  so  far  as  common  stock  is  concerned,  but  is  no 
longer  universal.  Certain  important  modifications  of 
the  custom,  which  have  become  more  and  more  popular, 
should  be  noted. 

The  chief  objection  to  the  original  custom  is  that  it 
puts  the  control  of  the  corporation  absolutely  in  the 
hands  of  the  owners  of  the  majority  of  the  stock.  Un- 
der this  custom  they  elect,  not  merely  the  majority,  but 
all  of  the  members  of  the  board  of  directors.  Hence  the 
minority  stocldiolders  may  find  themselves  unrepresented 
and  absolutely  powerless.  This  is  unfortunately  the 
condition  of  the  minority  in  almost  all  American  corpo- 
rations. 

In  order  to  provide  to  some  extent  against  this,  ac- 
knowledged evil  and  the  abuses  which  are  likely  to  to  fol- 
low, it  is  very  common  in  England  to  restrict  the  number 
of  votes  allowed  to  any  one  stockholder.  Thus  a  man 
with  ten  shares  or  less  may  be  allowed  one  vote  for  each 
share ;  for  each  additional  share  up  to  twenty  he  may  get 


76  CORPORATION  FINANCE 

only  one-half  of  a  vote;  for  each  additional  share  up  to 
forty  he  may  get  only  one-quarter  of  a  vote,  and  so  on. 
As  each  company  prescribes  in  its  by-laws  its  own  rules  as 
to  voting,  there  are  naturally  a  great  many  variations  of 
this  arrangement.  The  object  evidently  is  to  give  the 
great  body  of  small  stockholders  a  voice  in  the  manage- 
ment of  the  company  and  to  make  it  impossible  for  any 
individual  or  small  clique  to  gain  absolute  control  with- 
out owning  all  or  nearly  all  the  capital  stock.  At  first 
glance  this  arrangement  seems  admirable.  It  would  be 
so  easy,  however,  for  a  large  stockholder  to  have  his 
stock  transferred  in  small  lots  to  various  employees  and 
members  of  his  family,  and  thus  retain  full  voting  power 
for  that  stock,  that  it  is  certain  that  the  principal  could 
never  be  made  to  work  effectively  under  American  con- 
ditions. The  only  reason  that  it  is  moderately  success- 
ful in  England  is  that  stock  is  on  the  whole  more  widely 
scattered  and  held  in  smaller  lots  than  in  this  country. 

A  far  more  effective  method  of  attaining  the  same 
end  is  "cumulative  voting."  Under  this  method  each 
share  has  as  many  votes  in  electing  directors  as  the  num- 
ber of  directors  to  be  chosen.  These  votes  may  be 
scattered  among  the  nominees  or  concentrated  on  one  or 
two  of  them  as  the  stockholder  sees  fit.  The  effect  is  to 
make  it  impossible  for  a  majority  to  elect  all  the  board; 
the  minority  at  least  secures  representation. 

To  illustrate  the  working  of  this  method,  take  a  cor- 
poration in  which  there  are  1000  voting  shares  and  five 
members  of  the  board  of  directors  to  be  elected;  each 
share,  then,  is  entitled  to  five  votes.  We  will  suppose 
that  there  is  an  organized  majority  of  550  shares  and  an 
organized  minority  of  450  shares.  Under  the  usual  ar- 
rangement a  majority  vote  would  be  cast  for  five  nom- 
inees, all  of  whom  would  represent  the  majority  stock- 


CORPORATE  STOCK  77 

holders.  Under  the  cumulative  voting  system,  however, 
each  share  having  five  votes,  the  majority  would  cast 
altogether  2,750  votes  and  the  minority  2,250.  The 
majority  could  safely  give  916  2-3  votes  to  each  of  three 
nominees  and  thus  elect  a  majority  of  the  board,  leaving 
the  other  two  directors  to  be  elected  by  the  2,250  votes  of 
the  minority.  But  if  the  majority  should  attempt  to 
elect  four  directors  they  could  give  only  687%  votes  to 
each  of  the  four,  whereas  the  minority,  if  well  organized, 
could  concentrate  their  votes  on  three  directors  and  give 
each  one  750  votes,  thereby  electing  a  majority  of  the 
board.  To  make  the  system  and  its  possibilities  per- 
fectly clear,  it  would  be  well  for  each  reader  to  construct 
mentally  a  number  of  similar  hypothetical  cases  and  to 
observe  how  readily  a  minority  under  this  system  may 
secure  control  of  the  board  of  directors,  if  the  majority 
stockholders  are  too  greedy. 

Cumulative  voting  is  an  ingenious  and  generally  a 
highly  desirable  method  of  conducting  corporate  elec- 
tions. As  was  stated  once  before,  the  constitution  of 
Pennsylvania  (Contains  a  clause  requiring  that  all  corpo- 
rations organized  under  the  laws  of  that  state  shall  con- 
duct their  elections  by  the  cumulative  voting  method. 
Opinions  may  differ  as  to  the  propriety  of  including 
such  a  provision  in  a  state  constitution.  There  can 
hardly  be  a  doubt,  however,  as  to  the  wisdom  of  putting 
it  into  the  by-laws  of  most  corporations.    . 

48.  Voting  trusts. — Another  method  of  protecting  the 
interests  of  minority  stockholders  and  of  the  creditors 
of  a  corporation  is  the  formation  of  a  voting  trust.  This 
is  an  agreement  under  which  a  majority  of  the  voting 
stock  of  a  corporation  is  placed  in  the  hands  of  trustees 
who  are  authorized  to  vote  it  under  whatever  limitations 
may  be  prescribed.     The  triistees  usually  issue  in  return 


78  CORPORATION  FINANCE 

for  the  stock  so  deposited  "voting  trust  certificates," 
which  certify  that  the  stock  is  held  in  trust  by  the  trustees 
and  which  may  be  sold  and  transferred  in  the  same  man- 
ner as  certificates  of  stock.  As  the  trustees  are  usually 
men  of  high  standing  who  are  under  instructions  to  vote 
the  stock  for  certain  officials  or  in  behalf  of  certain 
measures,  the  minority  stockholders  may  safely  feel  that 
so  long  as  the  agreement  exists  no  radical  change  in  the 
policy  of  the  corporation  can  take  place,  and  the  rights  of 
all  stockholders  alike  will  be  respected. 

A  voting  trust  agreement  which  seriously  restricts  the 
freedom  of  the  majority  stockholders  of  a  corporation 
is,  of  course,  not  likely  to  be  acceptable  to  those  stock- 
holders. The  agreement,  therefore,  as  might  be  ex- 
pected, is  not  often  made  except  under  strong  pressure. 
It  is  most  frequently  used  either  when  a  corporation  is 
first  formed  and  can  secure  additional  capital  on  no  other 
terms;  or  when  a  corporation  is  in  financial  difficulties 
and  its  creditors  are  in  a  position  to  demand  that  the 
management  be  intrusted  to  certain  men  and  that  a  well- 
defined  policy  be  pursued. 


CHAPTER  VI 

TYPES  OF  BUSINESS  CORPORATIONS 

49.  Further  classification  of  corporations, — So  far, 
our  only  classification  of  corporations  has  been  into  the 
two  groups,  stock  and  non-stock.  The  non-stock  cor- 
poration, as  has  been  said,  is  adapted  only  for  govern- 
mental, social,  eleemosynary,  educational  or  religious  in- 
stitutions, and  not  to  business  concerns,  the  prime  reason 
being  that  the  absence  of  stock  leaves  no  machinery  for 
obtaining  capital,  except  borrowing,  or  for  distributing 
profits.  We  have,  therefore,  dismissed  the  non-stock 
corporations  as  being  altogether  outside  the  scope  of  this 
volume. 

Stock  corporations  may  be  further  classified  as  quasi- 
public  and  private.  Quasi-public  corporations  are  those 
which  perform  a  service  for  the  whole  community  for  the 
sake  of  profits  to  the  owners  of  the  corporation.  The 
most  conspicuous  examples  are  steam  and  electric  rail- 
roads, water  companies,  gas  and  electric  light  companies 
and  telephone  and  telegraph  companies.  Quasi-public 
corporations  are  granted  special  franchises  and  powers, 
such,  for  instance,  as  the  right  of  eminent  domain,  and, 
on  the  other  hand,  are  pecuharly  subject  to  legislative 
control.  Private  corporations  are  those  which  carry  on 
any  business,  such  as  manufacturing,  trading,  and  so 
on,  without  having  any  special  franchise,  entirely  for 
the  sake  of  profits  to. their  owners.  The  great  majority 
of  corporations  belong  in  this  second  classification. 

We  may  further  classify  this  last  group  on  the  basis 

79 


80  CORPORATION  FINANCE 

of  number  of  owners  into  "close"  and  "open"  corpora- 
tions. Close  corporations  are  those  in  which  the  shares 
of  stock  are  held  by  a  very  small  number  of  people  who 
do  not  expect  to  transfer  them.  Such  corporations  are 
not  much  in  the  public  eye,  since  their  affairs  are  of 
interest  to  only  a  few  individuals.  Frequently  a  "family 
business,"  which  has  been  organized  as  a  kind  of  loose 
partnership  for  many  years,  is  turned  into  a  corporation 
and  none  but  members  of  the  family  are  stockholders  in 
the  corporation.  Sometimes  estates  are  put  by  execu- 
tors into  the  corporate  form  for  ease  in  transferring  in- 
terests and  in  making  the  complicated  adjustments  at- 
tendant upon  the  settlement  of  a  large  estate.  These  are 
typical  instances  of  the  close  corporation.  By  an  open 
corporation  is  meant  one,  the  shares  of  which  are  held  by 
a  considerable  number  of  individuals  and  are  traded  in 
more  or  less.  It  is  called  open  because  anyone  who  has 
the  money  may  readily  buy  some  of  its  shares.  Most 
business  corporations  belong  in  this  class. 

We  shall  have  occasion  frequently  in  this  volume  to 
refer  to  both  "large"  and  "small"  corporations.  These 
words,  of  course,  have  no  absolute  meaning;  yet  in  con- 
nection with  corporations  a  fairly  definite  distinction 
between  them  may  be  drawn.  Generally  speaking,  when 
large  corporations  are  mentioned  we  shall  have  in  mind 
the  companies  which  operate  several  different  plants  or 
rail  lines,  particularly  the  big  railroad  consolidations  and 
industrial  trusts.  A  corporation  which  has  only  one 
plant,  even  though  it  be  of  considerable  importance  in 
its  own  community,  for  our  purpose  may  be  put  into  the 
class  of  small  or  local  corporations. 

Two  types  of  business  corporations  that  are  both 
prominent  and  important  in  present-day  industry  are  the 
parent  company  and  the  holding  company.     These  two 


TYPES  OF  BUSINESS  CORPORATION  81 

types  are  frequently,  even  usually,  confused,  although 
the  distinction  between  them  should  be  kept  in  view. 

50.  The  parent  company, — A  parent  company  is  one 
that  for  some  reason  does  not  desire  to  carry  on  opera- 
tions in  its  own  name  over  the  whole  country,  and  which 
therefore  organizes  and  holds  all  or  nearly  all  the  stock 
of  one  or  more  subordinate  companies.  There  may  be 
several  reasons  for  so  doing.  The  parent  company  may 
wish  to  operate  in  other  countries  than  the  United  States, 
in  which  case  it  will  obviously  be  necessary  to  form  a 
separate  corporation  in  each  country.  Several  English 
companies,  for  instance,  have  subordinate  companies  in 
this  country  and  a  great  many  American  companies  have 
British  subordinate  corporations.  Another  reason  for 
this  method  of  organization  is  to  avoid  excessive  local 
taxation.  As  the  capitalization  of  each  of  the  subordi- 
nate corporations  may  be  low,  and  as  the  parent  company 
is  not  officially  known  to  the  authorities  of  the  states  in 
which  the  sub-companies  are  located,  the  taxes  paid  to 
these  states  are  by  this  means  much  reduced.  Another 
frequent  reason  is  that  it  is  desirable  to  have  local  men 
in  charge  of  various  plants  of  the  corporation  and  to 
give  these  men  a  stock  interest,  not  in  the  corporation  as 
a  whole,  but  in  the  branch  under  their  control.  This  is 
best  accomplished  by  the  organization  of  a  subordinate 
company  at  each  branch.  Obviously  a  parent  company 
is  also  a  holding  company  in  the  sense  that  it  owns  the 
stock  of  other  corporations;  but  these  subordinate  com- 
panies have  been  created  by  its  officers  in  its  interest,  and 
are  in  reality  simply  forms  in  which  sections  of  its  busi- 
ness are  organized. 

51.  Nature  of  a  holding  company, — A  holding  com- 
pany proper,  on  the  other  hand,  using  the  term  in  a 
financial,  not  a  legal,  sense,  comes  into  existence  ft)r  the 

1—6 


82  CORPORATION  FINANCE 

purpose  of  buying  control  of  pre-existing  companies. 
Its  ostensible  object  is  the  buying  of  securities  of  other 
corporations  to  be  held  for  whatever  revenues  they  will 
produce.    The  real  object  of  its  existence,  however,  is  not 
accomplished  unless  it  holds  control  of  all  its  subsidiary 
companies  and  directs  their  operations.     Sometimes  this 
control  consists  in  holding  a  bare  majority  of  the  voting 
stock  of  the  subsidiary;  but  it  is  generally  advisable  to 
secure  as  much  stock  as  possible,  for  the  greater  the  ex- 
tent of  the  control,  the  more  readily  may  the  holding 
company  carry  out  its  plans  to  achieve  economies  and 
fix  prices.     As  we  shall  see  in  our  later  discussions  of 
industrial  combinations,  the  process  of  economizing  fre- 
quently involves  loss  to  one  or  more  of  the  subsidiary 
companies;  that  is  to  say,  production  is  often  concen- 
trated in  the  best  plants  and  the  poor  plants  are  allowed 
to  fall  into  decay.     If  there  is  a  considerable  minority 
interest  in  any  of  these  poorly  equipped  subsidiary  com- 
panies, there  will  inevitably  be  strong  objections  and 
legal  obstacles  to  the  plans  of  the  holding  company.     It 
is  also  to  the  holding  company's  interest  to  own  as  much 
as  it  can  get  of  the  stock  of  those  subsidiary  companies 
the  business  and  profits  of  which  it  intends  to  expand. 
Thus  a  holding  company  almost  always  aims  to  be- 
come practically  the  sole  stockholder  in  its  subsidiary 
companies,  so  that  it  may  operate  their  properties  un- 
hindered.    Although  in  theory  it  merely  holds  securities, 
in  practice  it  is  the  virtual  owner  of  the  railroads,  the 
mines,  the  plants  and  the  other  property  of  its  subsid- 
iaries.    We  see  an  expression  of  this  dual  relation,  the 
nominal  and  the  virtual,  in  the  reports  of  almost  all  hold- 
ing companies.     In  these  reports  we  almost  always  find 
two  balance  sheets  and  two  income  statements.     The 
first  balance  sheet  shows  as  assets  of  the  holding  company 


TYPES  OF  BUSINESS  CORPORATION  83 

simply  the  securities  in  its  treasury  and  the  first  income 
statement  reports  merely  the  dividends  and  interest  re- 
ceived on  those  securities ;  the  second  balance  sheet — us- 
ually called  "consolidated"  or  "general" — shows  as  assets 
the  physical  property  of  the  subsidiary  companies  and 
the  second  income  statement  shows  their  combined  prof- 
its. A  lack  of  knowledge  of  these  simple  facts  has 
frequently  caused  confusion  in  the  minds  even  of  stock- 
holders of  holding  companies,  many  of  whom  do  not 
understand  the  status  of  their  own  company. 

52.  The  holding  company  as  a  means  of  organizing 
^'trusts." — The  holding  company  is  the  method  now  used 
in  organizing  those  vast  industrial  and  railroad  consoli- 
dations that  are  called  trusts.  Two  former  methods  of 
forming  such  combinations  were  pools  and  trusts — this 
word  being  used  in  this  instance  not  in  its  popular,  but 
in  its  legal  sense.  The  pool  is  a  more  or  less  formal 
agreement  among  manufacturers  of  any  given  com- 
modity to  limit  production  and  to  maintain  prices; 
sometimes  this  agreement  includes  the  organization  of 
a  central  selling  agency  .through  which  all  the  manufac- 
turers dispose  of  their  product.  Trusts — in  the  legal 
sense — worked  on  a  different  principle ;  the  holders  of  the 
voting  securities  of  competing  companies  turned  over  at 
least  a  majority  interest  in  each  company  to  one  man  or 
a  small  group  of  men  to  hold  in  trust,  and  received  in 
return  what  were  known  as  trust  certificates.  In  other 
words,  a  single  voting  trust  for  a  number  of  competing 
companies  was  formed.  The  trustees  had  power  ,to  vote 
all  the  stock  in  their  possession  and  thus  exercise  control 
over  the  policies  of  competing  companies.  Pools  proved 
to  be  unworkable  and*  trusts  illegal,  for  reasons  which  it 
belongs  to  the  science  of  economics  rather  than  to  corpo- 
ration finance  to  discuss,  and  both  have  been  given*up  in 


84»  CORPORATION  FINANCE 

favor  of  the  modern  form  of  combination,  the  holding 
company. 

The  holding  company  was  first  made  possible  in  1889 
by  an  amendment  to  the  corporation  law  of  the  State  of 
New  Jersey,  which  reads  as  follows: 

Any  corporation  may  purchase,  hold,  sell,  assign,  transfer, 
mortgage,  pledge,  or  otherwise  dispose  of  the  shares  of  the  cap- 
ital stock  of,  or  any  bonds,  securities,  or  evidences  of  indebted- 
ness created  by  any  other  corporation  or  corporations  of  this  or 
any  other  state,  and  while  owner  of  said  stock  may  exercise  all 
the  rights,  powers,  and  privileges  of  ownership,  including  the 
right  to  vote  thereon. 

Professor  Edward  Sherwood  Meade,  of  the  Univer- 
sity of  Pennsylvania,  includes  in  his  valuable  work  on 
Trust  Finance  some  remarks  as  to  the  meaning  and 
results  of  this  Act  which  are  of  such  interest  and  im- 
portance that  they  are  presented  below  in  full: 

For  momentous  consequences,  this  statute  of  New  Jersey  is 
hardly  to  be  equaled  in  the  annals  of  legislation.  Sixteen  sov- 
ereign states  had  passed  searching  and  stringent  laws  in  pro- 
hibition of  any  attempt  to  restrict  competition ;  laws  whose  de- 
tailed minuteness  of  specification  could  hardly  be  improved 
upon;  which  had  been  proved  effective  against  the  only  per- 
manent form  of  competition  regulation  yet  attempted,  and  which 
undoubtedly  represented  the  conviction  of  a  majority  of  the 
people  of  the  United  States — a  conviction  finding  more  general 
and  authoritative  expression  in  the  Sherman  Anti-trust  Law, 
and  strengthened  by  the  anti-monopoly  provisions  of  the  common 
law;  a  well-nigh  unanimous  sentiment  opposed  to  any  form  of 
trust  or  pool ;  and  the  little  State  of  New  Jersey,  containing  two 
per  cent  of  the  population  and  one  and  three-tenths  of  the 
wealth  of  the  United  States,  by  the  simple  act  of  amending  its 
corporation  law,  nullified  the  anti-trust  laws  of  every  state  which 
had  passed  them. 


TYPES  OF  BUSINESS  CORPORATION  85 

A  trust  could  not  exist  in  New  York.  The  courts  of  New 
York  would  not  allow  the  creation  of  a  holding  company  to  per- 
petuate the  trust  under  another  and  slightly  different  form. 
Here  are,  say  ten  corporations,  all  located  in  New  York,  which 
were  formerly  engaged  in  competition,  later  organized  into  a 
trust,  and  more  recently  dissolved  by  the  New  York  courts. 
The  owners  of  these  corporations,  having  experienced  the  bene- 
fits of  combination,  wish  to  continue  their  organization  under 
another  form.  They  apply  to  the  New  York  Legislature  for 
permission  to  charter  a  new  company  which  shall  purchase  all 
their  stock,  and  whose  officers  can  thus  control  their  united 
policy.  The  Legislature  refuses  the  application  on  the  ground 
that  the  new  corporation  would  be  the  old  trust  under  a  new 
name,  and  would  therefore  be  existing  in  violation  of  the  same 
law  which  had  been  recently  employed  against  its  predecessor. 
The  case  of  the  stockholders  seems  hopeless.  They  are  citizens 
of  New  York.  Their  corporations  are  chartered  by  New  York. 
New  York  absolutely  forbids  them  to  combine  in  restraint  of 
trade.     What  are  they  to  do  ? 

In  despair  they  turn  their  eyes  southward.  There,  upon  the 
other  side  of  the  North  River  stands  the  State  of  New  Jersey, 
beckoning  them  with  welcoming  hands.  For  a  franchise  bonus 
or  fee.  New  Jersey  will  come  to  their  assistance.  New  Jersey 
will  authorize  them  to  form  a  corporation  which  is  empowered  to 
buy  the  stocks  of  their  ten  companies.  New  Jersey  will  allow 
them,  as  a  New  Jersey  corporation,  to  perfect  the  combination 
in  New  York — for  operation  in  New  York — which  the  laws  of 
New  York  absolutely  forbid.  New  Jersey  will  thus  deprive  the 
State  of  New  York  of  the  right  to  control,  in  the  interests  of 
what  her  Legislature  considers  to  be  public  policy,  the  corpora- 
tions which  New  York  has  created  and  over  which  it  assumes 
sovereign  power.  New  Jersey  will  perform  a  similar  office  for 
any  body  of  individuals  who  may  wish  to  evade  the  anti-trust 
laws  of  any  State  in  the  Union.  As  a  New  Jersey  corporation, 
they  may  combine  and  coalesce  for  the  operation  of  any  num- 
ber of  competing  plants,  anywhere  in  the  United  States^  with 
none  to  molest  or  make  them  afraid. 


86  CORPORATION  EINANCE 

This  quotation  is  not  intended  to  give  the  impression 
that  holding  companies  are  necessarily  formed  in  every 
instance  for  unlawful  or  harmful  purposes.  On  the 
contrary,  the  writer  wishes  to  record  here  his  conviction 
that  some  form  of  industrial  and  railroad  combination 
under  present  conditions  in  this  country  is  both  inevitable 
and  desirable.  It  is  inevitable  because  by  means  of 
combination  production  as  a  rule  can  be  carried 
no  more  cheaply  than  would  otherwise  be  possible; 
it  is  desirable  because  through  the  working  of  economic 
forces  the  advantages  gained  by  this  cheapness  of 
production  will  be  distributed  in  the  long  run  among 
all  classes.  To  defend  and  illustrate  this  proposition 
would  lead  us  too  far  away  from  our  main  subject.  The 
statement  is  worth  bearing  in  mind,  however,  especially 
by  those  persons  who  are  prone  to  join  in  thoughtless 
outcry  against  the  "trusts." 

53.  Compleooity  of  holding  companies. — Holding 
companies  may  be  formed,  not  only  to  acquire  stock  of 
operating  companies,  but  also  to  obtain  control  of  other 
holding  companies;  then  there  is  no  reason,  of  course, 
why  the  stock  of  the  second  holding  company  should  not 
be  purchased  sooner  or  later  by  a  third  still  greater  hold- 
ing company.  Thus  there  may  be  built  up  a  most  in- 
tricate and  extensive  organization,  in  which  so  many 
companies  may  be  involved  that  it  becomes  a  difficult 
matter  to  trace  their  relations  to  each  other.  Many  ex- 
amples, each  of  which  would  require  considerable  expla- 
nation, might  be  given.  The  reader  will  get  a  sufficiently 
clear  idea,  however,  as  to  how  complex  organizations  of 
this  kind  are  built  up  if  he  will  study  the  accom- 
panying chart  of  the  Interborough-Metropolitan 
Company,  which  was  prepared  for  the  Public  Service 
Commission    of   the    First   District   of   the    State    of 


MANHATTAN  RYT  CO. 

(lie  nil.C9  OP  UXVWTCO TRACK) 

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STOCK  •e.oooieoo 

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1 B  T  CO  ov»~e  «ea.eoo  or  ♦loo.ooo.or  sto;jk 

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INTERBOROUGH  RAPID  TRANSIT  CO. 
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•OrNeWVORK..   ATA  RKrtTAk  IN  l907  0P4^789.S4«.i9 
CAPITAL  STOCK.  ♦35.000,000 

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(  7dt.A-7  MILES  or  track) 


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x 


i.ilT.ca:owHS«4S)Scs  or  stock 

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I.H.T.Ca»WW9«»7,<looorBONOS 


THE  LONG  ISLAND  RR.CO. 
HrtSAN  INTEREST  IN  THESE 
COS  EQUALTO  THATOFTWt 
INTER  BOROUGH  R.  T.  CO, 


INTERBOROUGI 


STOCK       PRcrEanEO 


BONDS  COL.  TRUST.- 
NOTES  COL  TRUST  1 
THISCOMRANVOtffNS  Tl 
INTCRBOROUeH  R  T.CO. 
MCTItoPOLlTAN  STREE 
METROPOLITAN   SCCUI 


I.R.TCO.   •soo^asi 
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♦'lER. 


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vBo.ooo       aarera 
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78C.7MILC9  or  TRACK)     owNeo   By 
*  TOTAL  '         I.W.TCO. 

STOCK  4«o<tooo.         ^eea.ooo. 

BONDS  8)4ia«8    aoo.ooo  soo.oo* 


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HtT.sEc  ca  ov<N«  4aoA*oe  or  stock 

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^  TOTAL       PLEDCEO 

BONDS  «VMts«>». aw  •laoaeeoL 

INCOME  C>iai8     i.eooooo4(.4«o.ooo 
MORTGAGES  loo.ooft   all 

NOTES  FWyABLC  fiaas.^oo  «.<M,»«7 

STOCK  s»'8oaooo.(.«7iiioo 


KINGSBRIDGE  R.R.CO. 

(  •aa  HtLCS  or  TRACK.) 

NOTES  PAYABLE  |  ^..^sjisas  |  a!^^* 
STOCK  e,ao©        all 


DRY  DOCK.EASTDROADV«W86 
BATTERY  R.R.CO, 

/  17. 97  MILES  or  TRACK  ) 


GENL  MTG.  S9»<att  •aeqeoa 

CT'r  S  orlNOEB  ai«(«iiBtt*o.)*i,io«xooc 
NOTES  rVXVABLE,  «i.ss«eM  fianaM 

STOCK  (.goQooo  oaa^eo 


MCT.«EX:.C0.0nNe»e^970.00OOF  STOCK 

THIRD  AVTS:.R.R.CO. 

f  aaa  mileo  or  track) 
STOCK  f  15.995.800 

&ONDS  1^  M^rG.3^  1937  as.ooo.ooo 
|WCON4t*ecwo    37.560.000 

NOTES  OWNED  BVKftRltCO.  B.367.6aa 
this  CO.  WAS  LEASED  BV  M.eRv;COATA 
RENTAL     or     «^  ON    T«t    STOCK. 


THE   SCCURITieSOF.THESECOMPANlES 
NOTED  AS  PLEDGED    ARE  DEPOSITED 

UNDER  THE  3«>AVE.R.RCOSFIRSl 
CONSOLIDATED  WORTGAGE 

OA3^E.D   MAY  iS^JSOtt. 
THE    STOCKS  SO  PUEOSEb  ARE 
OWNED   BY   THE    NEW   YORK 
CITY   RAILWAY  CO. 


Z 


UNION  Rv:co. 

(  SI.B  MiLEB  or  track) 

*  TOTAL 

BONDS  IVM.T.G.S/*  1*48  ia.ooo.ooo. 


NOTES  PAYABLE 
STOCK 


4.e4e.07T  ♦4,71! 

a,ooo,ooe         « 


OPERATED  BY   THE    OfllONRY.CO. 

BRONX  TRACTION  C( 

ie.77  MILE.S  or  TRACK 

STOCK  •  WSkioo 

NOTES  PAYABLE  i6i.«.M 


YONKERS   R.RCO. 

(«4.46  M1LC8  or  track) 
BONDS  IWMlTViBJua^a  4i.oo<40oo 
NOTES  PAYABLE  i4eB.4»l  ^I.IO 

STOCK  i.ooo.o'oo      9^ 


TARRYTOV/N,  WHITE  PLA 
JJ^ViMARONE  CK .  RAILWAY 
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Public  Service  Commission. 


TYPES  OF  BUSINESS  CORPORATION  87 

New  York.  The  Interborough-Metropolitan  Company 
controls  all  the  street  car,  elevated  and  subway  railway 
lines  in  the  principal  boroughs  of  New  York  City.  It 
was  formed,  as  shown  in  the  chart,  by  an  exchange  of  its 
securities  for  the  securities  of  two  formerly  competing 
companies,  the  Metropolitan  Securities  Company  and  the 
Interborough  Rapid  Transit  Company.  The  relations 
of  these  two  companies  to  each  other,  to  their  direct  sub- 
sidiaries, and  to  the  subsidiaries  of  their  subsidiaries,  are 
as  clearly  as  possible  presented  in  the  chart. 

54.  Organization  of  the  Standard  Oil  Company, — To 
illustrate  further  the  extent,  as  well  as  the  complexity, 
of  the  organization  of  a  great  holding  company,  there  is 
presented  below  the  most  complete  list  ever  published  of 
the  subsidiaries  controlled  by  the  Standard  Oil  Company 
of  New  Jersey.  The  reader  will  find  this  list  of  value, 
not  only  for  the  present  purpose,  but  for  future  refer- 
ence. The  Standard  Oil  Company  of  New  Jersey  is 
the  "parent"  of  something  over  half  of  the  subsidiaries 
shown  in  this  list;  it  is  a  true  holding  company,  in  the 
sense  in  which  that  term  has  been  defined  in  this  chapter, 
so  far  as  the  other  subsidiaries  named  are  concerned. 


I.  COMPANIES  WHOSE  STOCK  IS  OWNED  DIRECTLY  BY  THE 
STANDARD  OIL  COMPANY 

Total    Per  Cent 

Capital  Owned  by 

Name.  Stock.   Standard, 

Anglo-American    Oil    Co.,    Ltd $5,000,000  100 

Atlantic  Refining  Co 5,000,000  100 

Bedford  Petroleum  Co 350,000  99.3 

Borne-Scrymser  Co 200,000  99.9 

Buckeye  Pipe  Line  Co 10,000,000  100 

Carter  Oil  Co 2,000,000  100 

Chesebrough  Mfg.  Co 500,000  55.5 

Continental   Oil   Co 300,000  100 

Colonial  Oil  Co 250,000  99.7 

Crescent  Pipe  Line  Co 3,000,00(T         100 


88  CORPORATION  FINANCE 

Total    Per  Cent 
Capital    Ownedhy 

Name.  Stock,   Standard. 

Clarksburg  Light  &  Heat  Co 100,000           51 

Deutsch-Amerikanische  Petroleum  Gesellschaf t 2,250,000  100 

Deutsch-Amerikanische        Petroleum        Gesellschaft  , 

(share  warrants)   5,250,000            99.9 

Empire   Refining   Co 100,000            78.5 

Empreza  Industrial  de  Petrolio 500,000            70 

Eureka  Pipe  Line  Co 5,000,000  100 

Forest  Oil  Co ?                    ? 

Gilbert  &  Barker  Mfg.  Co 40,000  100 

Galena-Signal  Oil  Co.  pfd 2,000,000            74.4 

Galena-Signal  Oil  Co.  com 8,000,000            70 

Hazelwood  Oil  Co ?                    ? 

Hope  Natural  Gas  Co 500,000  100 

Indiana  Pipe  Line  Co 1,000,000  100 

Interstate  Cooperage  Co 200,000  100 

Lawrence  Natural  Gas  Co 450,000  100 

Mahoning  Gas  Fuel  Co 150,000  99.9 

Marion   Oil   Co 100,000  50 

Mountain  State  Gas  Co 500,000  100 

National  Transit  Co 25,455,200  99.9 

New  York  Transit  Co 5,000,000  100 

Northern  Pipe  Line  Co 4,000,000  100 

Northwestern  Ohio  Natural  Gas  Co 2,775,250  59.4 

Ohio  Oil  Co 10,000,000  99.9 

People's  Natural  Gas  Co 1,000,000  100 

Pennsylvania  Lubricating  Co 50,000  60 

Pittsburg  Natural  Gas  Co 310,000  100 

Romano- Americana 2,500,000  100 

Reserve  Gas  Co 2,225,000  50 

Raffinerie    Franyaise 80,000  100 

River  Gas  Co ■. 190,000  5^.Q 

Solar  Refining  Co 500,000  99.8 

Southern  Pipe  Line  Co 10,000,000  100 

South  Penn  Oil  Co 2,500,000  100 

South  West  Pennslvania  Pipe  Lines 3,500,000  100 

Standard  Oil  Co.,  California    17,000,000  99.9 

Standard  Oil  Co.,  Indiana    1,000,000  99.9 

Standard  Oil  Co.,  Iowa    1,000,000  100 

Standard  Oil  Co.,  Kansas    1,000,000  99.9 

Standard  Oil  Co.,  Kentucky    1,000,000  99.9 

Standard  Oil  Co.,  Nebraska    600,000  99.9 

Standard  Oil  Co.,  New  York     15,000,000  100 

Standard  Oil  Co.,  Ohio    3,500,000  99.9 

Swan  &  Finch  Co 100,000  100 


TYPES  OF  BUSINESS  CORPORATION  89 

Total    Per  Cent 

Capital    Owned  by 

Name,  Stock.   Standard. 

Underhay  Oil  Co 25,000  98.8 

Union  Tank  Line  Co 3,500,000  99.9 

Vacuum  Oil  Co 2,500,000  100 

Waters-Pierce  Oil  Co 400,000  68.6 

West  India  Oil  Refining  Co 300,000  50 

West  Virginia  Oil  Co 200,000  50.6 

West  India  Oil  Co 100,000  99.3 

Washington  Oil  Co 100,000  71.4 

II.  COMPANIES  WHOSE  STOCK  IS  OWNED  PRIMARILY  BY 
SUBSIDIARY  COMPANIES 

Amerikanische  Petroleum  Anlagen $187,500  100 

Automaat    Co 10,000  100 

Eschweiler  Petroleum  Import 7,500  25 

Ghent  Petroleum  Co 200,000  60 

Hollandsche  Petroleum  Vereeniging 12,000  100 

Mannheim  Bremer  Petroleum  Actien  Gesellschaf t . . .  750,000  100 

Petrolifere   Ghent 20,000  74.5 

Petrolifere    Nationalc 10,000  100 

Petroleum  Raff,  vorm  August  Korff 375,000  54.6 

Societe  Anonyme  H.  Reith  Co 412,500  61 

Rheinische  Petrol.  Actien  Gesellschaf t 250  100 

Actien  Gesellschaft  Atlantic 287,500  60 

American  Petroleum  Co 3,140,000  51.3 

Street  Tank  Wagon  Business-Duren 4,250  71 

Gibraltar  Petroleum  Co 25,000  100 

Imperial  Oil  Co.,  Ltd 4,000,000  83.1 

Det  Danske  Petroleums  Aktieselskab 756,000  51.3 

Tidewater  Oil  Co 20,000,000  31.1 

Tank  Storage  and  Carriage  Co.,  Ltd.  pfd 300,000  100 

Tank  Storage  and  Carriage  Co.,  Ltd.,  ordinary 42,195  100 

Societa  Italo-Americana  pel  Petrolio 1,000,000  60 

Aktieselskabet  Ostlandske  Petrol.  Cie 162,000  9.2 

Krooks  Petrol,  and  Olje  Aktiebolag 270,000  10 

Skanska  Petroleums  Aktiebolaget 135,000  60 

Svenska  Petroleums  Aktiebolaget 27,000  75 

Sydvenska  Petroleums  Aktiebolaget 98,550  24.7 

Kestkustens  Petroleums   Aktiebolag 177,500  15.3 

Koenigsberger  Handels  Compagnie 575,000  49.8 

Petroleum  Import  Compagnie 80,000  100 

Schweizerische  Petroleum  Handels  Gesellschaft 60,000  60 

Societe  Anonyme  Petrolea 80,000  66.5 

Wachs.  &  Flossner  Petrol.  Gesellschaft,,,.,,,,,,..  25,000      *  100 


90 


CORPORATION  FINANCE 


Total    Per  Cent 

Capital   Owned  by 

Name.  Stock.   Standard. 

Westphalische  Petroleum  Gesellschaft 25,000  100 

S.  T.  Baker  Oil  Co 50,000  100 

Galena  Oil  Co. —  Societe  Anonyme  Fran9aise 40,000  100 

Queen  City  Oil  Co.,  Ltd 200,000  87.4 

Connecting  Gas  Co 825,000  49.9 

Cumberland  Pipe  Line  Co 1,000,000  99.9 

East  Ohio  Gas  Co 6,000,000  100 

Franklin  Pipe  Line  Co 50,000  39 

New  Domain  Oil  and  Gas  Co , 1,000,000  99.9 

Prairie  Oil  and  Gas  Co 10,000,000  100 

St.  Paul  Petroleum  Tanks   (Lim.) 250,000  55 

Societa  Meridionale  pel  Commercio  del  Petrolic 120,000            

Societa  per  gli  Olii  Minerali 156,000  52.1 

Society  Tunsienne  des  Petroles 80,000  65 

International  Oil  Co.,  Ltd 2,750,000  99.4 

Vacuum  Oil  Co.,  Proprietary  Limited 500,000  100 

Vacuum  Oil  Co.,  Reszvenytarsasag    2,100,000  100 

Vacuum  Oil  Co.,  Limited 275,000  99.9 

Vacuum  Oil  Co.— Soci^t6  Anonyme  Fran^aise 400,000  100 

Deutsch  — Vacuum  Oil  Co 625,000  100 

Vacuum  Oil  Co.—  Societa  Anonyme  Italiana 100,000  100 

Vacuum  Oil  Co.—  Aktiebolag 27,000  96.6 

Taylorstown  Natural  Gas  Co 10,000  70 

Total    $229,963,195 

Standard  Oil  Co.  of  New  Jersey 98,338,300 

Grand  total  $328,301,495 


CHAPTER  VII 

SOURCES  OF  CORPORATE  FUNDS 

55.  Summary  of  preceding  chapters, — The  first  six_ 
chapters  of  this  book  cover  those  fundamental  features 
of  corporation  law  which  are  essential  to  an  understand- 
ing of  the  financial  organization  and  management  of 
corporations.  We  have  taken  up  in  turn  among  other 
topics :  the  advantages  of  corporations  over  other  forms 
of  conducting  business ;  the  legal  powers  of  the  corpora- 
tion; the  charter;  the  by-laws;  the  duties,  rights  and 
privileges  of  stockholders;  of  directors;  of  officers;  the 
process  of  incorporation ;  the  factors  to  consider  in  select- 
ing the  state  of  incorporation;  the  relative  advantages 
and  disadvantages  of  several  states;  the  characteristics 
of  common  and  preferred  stock;  the  uses  of  cumulative 
voting  and  of  voting  trusts ;  the  nature  of  a  close  corpo- 
ration; of  an  ordinary  operating  company;  of  a  parent 
company;  of  a  holding  company.  All  of  this  matter, 
although  essential,  is  intended  merely  as  an  introduction 
to  what  follows.  Our  real  subject  is  not  the  legal,  but 
the  financial,  side  of  corporation  practice,  and  this  sub- 
ject we  are  now  ready  to  take  up.  It  must  not  be  for- 
gotten at  any  stage  of  this  study,  however,  that  all  finan- 
cial measures  must  comply  with  and  be  in  harmony  with 
the  legal  principles  that  have  been  discussed. 

56.  Four  sources  of  corporate  funds, — In  financing  a 
corporation  the  managers  may  go  for  funds  to  six  dif- 
ferent sources,  as  follows:  ~V" 


92  CORPORATION  FINANCE  ^ 

(a)  Active  interests  in  the  business 

(b)  Profits  of  the  business 

(c)  Trade  creditors 

(d)  Banks 

(e)  The  investing  pubhc 

(f)  The  speculative  pubHc. 

There  is  no  need  of  discussing  in  detail  methods  of 
raising  funds  from  people  who  are  actively  engaged  in 
the  management  of  the  corporation.  Each  one  presum- 
ably will  be  fully  informed  as  to  the  records  and  pros- 
pects of  the  company  and  will  regulate  his  investments 
accordingly.  In  the  case  of  close  corporations  the  proc- 
ess of  raising  funds  is  simply  to  allow  each  person  in- 
terested to  invest  as  much  as  he  can  and  will  on  terms 
that  are  settled  by  direct  bargaining. 

Profits  that  are  not  paid  out  from  a  surplus  that  may 
be  one  of  the  most  important  sources  of  funds.  The 
Carnegie  Steel  Company,  as  we  shall  see  later,  is  a  con- 
spicuous example.  This  particular  topic  is  fully  dis- 
cussed in  later  chapters  and  need  only  be  mentioned 
here. 

It  may  not  be  plain  at  first  sight  that  the  trade  cred- 
itors of  a  concern  are  in  reality  furnishing  part  of  the 
funds  necessary  to  the  business;  but  a  moment's  reflec- 
tion makes  it  evident  that  a  company  which  continually 
carries,  say,  $10,000  of  accounts  payable,  thereby  makes 
that  amount  available  for  its  business.  If  the  trade  cred- 
itors should  demand  cash  for  every  purchase,  the  concern 
would  have  to  raise  the  $10,000  from  some  other  source. 
In  some  lines  of  business,  especially  retail,  a  very  small 
investment  is  sufficient  to  carry  on  comparatively  large 
operations  simply  because  long-time  payments  are  per- 
missible. Usually,  however,  the  merchant  or  manufac- 
turer who  buys  on  credit  also  sells  on  credit,  in  which 


SOURCES  OF  CORPORATE  FUNDS  93 

case  the  funds  derived  from  trade  creditors  are  promptly 
placed  at  the  disposal  of  trade  debtors. 

Of  course,  it  is  possible  also  that  a  business  may  draw 
its  funds  from  the  advance  payments  of  the  people  who 
buy  its  products;  but  this  is  so  unusual  a  case  that  it  is 
hardly  worth  mentioning. 

Banks  are  institutions  whose  primary  function  is  to 
furnish  funds  for  commercial  enterprises.  Without  go- 
ing into  the  theory  of  banking,  it  may  be  pointed  out 
that  banks  are  dealers  in  credit.  They  buy  the  credit 
of  other  people  in  the  form  of  notes  and  similar  obliga- 
tions and  they  sell  their  own  credit  principally  in  the 
form  of  deposits.  Any  reader  to  whom  this  statement 
is  not  altogether  clear  may  turn  to  the  volume  on  Money 
ANii  Banking  for  further  enlightenment.  In  order  to 
make  its  credit  good  a  bank  must  always  be  ready  to  re- 
deem promptly  every  check  that  may  be  presented  to  it 
for  payment.  Therefore,  a  well-managed  bank  will 
never  tie  up  its  assets  in  permanent  investments,  but  will 
keep  them  always  "liquid."  For  that  reason  the  corpo- 
ration manager  can  look  to  banks  only  for  short-time 
loans,  usually  not  longer  than  ninety  days.  We  will  dis- 
cuss the  requirements  of  banks  in  detail  in  the  next  chap- 
ter. It  is  enough  for  the  present  to  say  that  funds  se- 
cured from  banks  will  almost  always  be  short-time  loans 
in  strictly  limited  amounts  backed  by  unexceptional  se- 
curity. • 

57.  The  investing  public  as  a  source  of  funds. — The 
fifth  source  of  funds  is  the  investing  public.  This 
phrase  covers,  not  only  individuals,  but  institutions.  The 
most  important  classes  of  investors  are;  (a)  professional 
and  salaried  people  who  have  no  business  of  their  own 
in  which  to  place  their  savings;  (b)  women  and  minors 
who  have  inherited  money;   (c)   estates  held  in  trust; 


94i  CORPORATION  FINANCE 

(d)  savings  institutions;  (e)  insurance  companies. 
Business  men  are  not  investors  in  securities  of  other  cor- 
porations than  those  in  which  they  are  directly  interested 
to  any  great  extent,  for  the  obvious  reason  that  they  are 
apt  either  to  put  their  savings  into  their  own  concerns 
or  to  seek  larger  returns  than  are  offered  by  strictly 
investment  securities. 

One  of  the  great  problems  of  raising  funds  for  many 
kinds  of  business  is  to  arouse  interest  and  inspire  confi- 
dence in  this  investing  public.  They  may  be  appealed 
to  by  advertisements  and  circular  letters — a  plan  which 
is  seldom  successful;  or  they  may  be  reached — usually 
with  much  better  results — through  bond  and  brokerage 
houses  whose  business  it  is  to  retail  investment  securities 
to  their  clients.  This  is  another  topic  that  will  come  up 
for  later  discussion. 

58.  Difference  between  investment  and  speculation. — 
This  is  a  good  place  to  define  the  words  "investment"  and 
"speculation."  The  former  word,  as  it  is  used  in  a  some- 
what technical  sense  by  the  leading  financial  papers,  re- 
fers to  a  security  or  other  property  which  is  practically 
certain,  so  far  as  human  minds  can  foresee,  not  to  de- 
preciate in  value.  No  security  in  which  the  element  of 
risk  is  prominent  can  properly  be  called  an  investment. 
If  the  probabilities  are  strong,  but  not  conclusive,  that 
the  security  or  property  will  not  depreciate  in  value,  then 
the  terms  semi-investment  or  semi-speculative  may  be 
applied.  To  illustrate,  a  United  States  Government 
bond  is  certainly  an  investment,  and  so  is  a  first  mortgage 
bond  on  any  of  the  standard  railroads.  Most  of  the  in- 
dustrial bonds,  however,  even  where  the  earnings  are 
large  and  the  prospects  apparently  good,  would  be 
classed  as  semi-investments,  because  there  is  always  dan- 
ger that  competition  or  some  new  invention  will  cut  into 


SOURCES  OF  CORPORATE  FUNDS  95 

the  business.  In  the  same  way  high-grade  preferred 
stocks  of  successful  railroads  and  industrial  companies 
would  be  called  either  semi-investment  or  semi-specula- 
tive issues.  For  our  purposes  in  this  book  these  finer 
distinctions  are  not  necessary  and  would  perhaps  be  con- 
fusing. We  shall,  therefore,  use  the  word  "investment" 
in  a  more  popular  sense  to  include  both  the  true  invest- 
ment and  the  semi-investment  or  semi-speculative  se- 
curities. We  may  define  it,  in  its  objective  sense, 
as  any  security  or  other  property  the  principal  of  which 
seems  safe  and  returns  on  which  (interest,  dividends  or 
rent)  seem  certain. 

The  great  majority  of  corporate  stocks  would  be 
classed  as  speculative ;  for  no  matter  how  promising  they 
may  be  conservative  brokers  would  not  in  most  cases  be 
willing  to  call  them  safe.     Calling  a  security  "specula- 
tive," the  reader  should  understand,  is  not  necessarily 
condemning  it  or  objecting  to  its  sale.     As  a  matter  of 
fact,  few  corporations  comparatively  have  anything  but 
speculative  securities  to  offer.     Moreover,  it  is  only  by 
more  or  less  speculative  purchases  that  returns  on  capital 
above  5,  6  or  7  per  cent  may  be  obtained.     Nearly 
all  investment  securities  have  been  at  one  time  specu- 
lative in  character.     When  the  terms  "highly  specu- 
lative" or  "purely  speculative"  are  used,  however,  it  is 
generally  safe  to  assume  that  the  writer  intends  to  convey 
the  idea  that  the  security  in  question  has  a  very  remote 
chance  of  ever  getting  into  the  investment  class. 
^  59.  The  speculative  'public  as  a  source  of  funds, — The 
speculative  public  may  be  roughly  subdivided  into  three 
groups:     (a)  ill-informed  people  who  do  not  know  the 
difference  between  an  investment  and  a  speculation  and 
who  are  continually  placing  their  hard-earned  money  in 
the  hands  of  unscrupulous  promoters  in  the  blind  faith 


96  CORPORATION  FINANCE 

that  they  are  making  an  investment;  (b)  intelligent 
business  and  professional  men  who  buy  and  hold  for  a 
rise  speculative  securities  and  property  in  the  full  knowl- 
edge that  they  are  taking  chances;  (c)  speculators  who 
buy  securities  and  property  "on  margin"  in  the  hope  of 
making  a  quick  and  large  profit.  Group  (a)  may  be 
reached  by  means  of  circular  letters  and  advertising; 
group  (b) ,  generally  by  personal  solicitation  or  through 
the  stock-market;  group  (c),  usually  through  the  stock- 
market.  A  detailed  discussion  of  the  methods  of  reach- 
ing and  interesting  possible  buyers  of  corporate  securi- 
ties must  be  deferred.  For  the  present  our  attention 
should  be  confined  to  the  securities  themselves. 

Corporate  funds  fall  into  two  classes:  borrowed 
funds  and  owned  funds.  The  borrowed  funds  are  se- 
cured through  accounts  and  bills  payable,  through  bank 
loans  or  through  bonds  and  mortgages.  The  owned 
funds  are  secured  through  issues  of  stock. 

60.  Desirability  of  borrowing  funds. — ^Why  should  a 
corporation  borrow  funds  at  all?  The  reader  will  per- 
haps answer,  as  many  people  do,  that  it  borrows  from 
necessity ;  that  as  soon  as  possible  it  ought  to  pay  off  its 
debts,  just  as  a  man  gets  rid  of  the  mortgage  on  his  house 
as  soon  as  he  can.  The  fact  is,  however,  that  for  a  cor- 
poration to  be  out  of  debt  is  no  credit  to  it,  but  rather  a 
sign  either  that  it  is  in  a  dangerous  position  or  that  it  is 
not  intelligently  managed.  Only  one  method  of  raising 
funds  is  cheaper  than  borrowing,  and  that  method  is 
stealing.  Therefore,  a  corporation  should  borrow  as 
much  as  it  can  within  the  limits  of  safety. 

To  illustrate  the  desirabihty  of  borrowing  part  of  the 
funds  of  a  corporation :  Suppose  a  manufacturing  com- 
pany needs  $100,000  to  carry  on  its  business  and  pro- 
duces an  average  net  income  of  $6,000.     If  it  raises  the 


SOURCES  OF  CORPORATE  FUNDS      97 

whole  $100,000  by  stock  issues,  it  will  only  pay  6  per 

cent  dividends — not  enough  to  compensate  for  the  risks 

and  uncertainties  of  the  business.     Now  suppose  that 

the  company  is  dissolved  and  the  same  business  is  carried 

on  under  a  new  company  which  sells  $50,000  of  5  per 

.      cent,  bonds,  gets  additional  and  larger  credits  to  the  ex- 

[     tent  of  $10,000  and  borrows  $5,000  from  banks  at  an 

3  average  rate  of  5  per  cent.     Then,  only  $35,000  stock 

0  need  be  issued,  the  income  of  which,  after  deducting  in- 

1  terest  charges  of  $2,750,  will  be  $3,250,  or  9.3  per  cent, 
^|2  a  satisfactory  return. 

\\i  Thomas  L.  Greene,  author  of  "Corporation  Finance," 
points  out  that  a  few  years  ago  three-quarters  of  owned 
to  one-quarter  of  borrowed  funds  was  thought  about 
right,  whereas  now  the  proportion  in  well-managed  cor- 
porations is  nearer  one-quarter  owned  to  three-quarters 
borrowed.  The  result  has  been  to  reduce  the  average 
rate  of  returns  on  capital  and  thereby  to  reduce  cost  of 
production  and  prices.  In  order  to  make  profits  at  all 
under  present  conditions  mercantile  and  manufacturing 
concerns  must  borrow  heavily.  Of  course,  there  are  lim- 
its to  the  safety  and  advantages  of  borrowing. 

On  the  following  pages  are  given  five  recent  balance 
sheets  (Herring-Hall-Marvin  Safe  Company,  Ameri- 
can Thread  Company,  Bethlehem  Steel  Company,  A. 
Booth  &  Company,  and  United  States  Leather  Com- 
pany) selected  practically  at  random,  which  will  perhaps 
make  these  statements  somewhat  more  vivid  and  con- 
crete. Assuming  that  the  balance  sheet  of  the  first- 
named  concern  is  based  on  the  actual  value  of  the  prop- 
erty (which  is,  to  be  sure,  a  pure  assumption)  we  arrive 
at  the  real  amount  of  funds  utilized  in  the  business  by 
deducting  from  the  total  assets  the  item  of  "Patents, 
trade-marks,    etc.,    $92,000,"    leaving    approxinfately 

1—7 


98  CORPORATION  FINANCE 

HERRING-HALL-MARVIN  SAFE  CO. 
Assets: 

Real  estate  and  buildings ^202,652 

Machinery,    &c 298,864 

Stocks  on  hand  at  cost 207,076 

Work  in  process  &  materials 320,988 

Bills  &  accts.  rec.  &  cash 372,830 

Insurance,  &c.,  paid  in  adv 8,095 

Stock  of  other  companies 1,000 

Patents,  trade-marks,  &c 92,000 

Total   $1,512,506 

Liabilities: 

Capital    stock $700,000 

Debentures  maturing  to  1915 410,000 

Bills    payable 170,354 

Accounts  payable 92,561 

Reserves  for  completion  of  contracts 64,208 

Contingent  liability  reserves 16,000 

Surplus  of  year's  operation 59,383 

Total   $1,512,506 


AMERICAN  THREAD  CO. 
Assets: 
Land,  water,  &  steam  power,  mills,  machinery,  plant 

&  effects $12,694,896 

Stocks-in-trade  at  net  cost 4,960,971 

Accounts  receivable,  net 1,016,445 

Cash  at  bankers  &  in  hand 341,483 

Sundry  investments 229,840 

Advance  payments 38,292 

.  Total    $19,281,927 

Liabilities : 

Com.  stock  ($3.50  paid  up) $4,200,000 

5%  Pfd.  stock  (fully  paid) 4,890,475 

4%  1st  mtge.  bonds 6,000,000 

English  Sew.  Cot.  Co.  Ltd 351,164 

Accounts  payable 770,410 

Bond   int.  accrued 60,000 


SOURCES  OF  CORPORATE  FUNDS      99 

Depreciation  fund 2,076,987 

Div.  on  com.,  payable  July 588,000 

Profit  &  loss 344,891 

Total    $19,281,927 


BETHLEHEM  STEEL  CO. 
Assets: 

Property  account $37,857,260 

1st  mtge.  bonds  reed,  in  part  payment  for  property  518,848 

Inventories    6,795,542 

Notes  and  accts.  receivable 2,513,186 

Cash  on  hand  &  in  bank 4,230,418 

Deferred  charges   943,a24 

Total    $52,858,578 

Liabilities; 

Capital  stock $29,770,000 

Bonds  of  Bethlehem  Steel  Co 16,159,000 

Notes  &  accts.  payable,  &c 5,735,154 

Bond  interest  accrued 103,145 

Reserved  for  depreciation 400,000 

Reserved  for  relining  furnaces,  &c 97,885 

Surplus    593,421 

Total  $52,858,578 


A.  BOOTH  &  CO. 

Assets: 

Cash    $510,777 

Merchandise    937,976 

Accounts   receivable 1,556,689 

Bills    receivable 930,560 

Unexpired  insurance,  R.  R.  mileage,  etc 119,448 

Treasury  preferred  stock 20,800 

Treasury  common  stock 170,650 

Plants,  steamboats,  real  estate,  etc 5,510,927 

Total $9,757,827 


100  CORPORATION  FINANCE 

Liabilities: 

Common  stock $3,000,000 

Preferred  stock 2,500,000 

Surplus   1,522,700 

Undivided  profits 202,138 

Accounts  payable 931,989 

Bills  payable I,601,i00 

Total    $9,757,827 


UNITED  STATES  LEATHER  CO. 
Assets: 

Cash    $2,505,159 

Due  by  customers 10,761,665 

Bills  receivable 1,277,339 

Doubtful  debts,   val 8,832 

Other  debtors 1,070,602 

Hides  &  leather 15,269,784 

Bark  at  tanneries 1,677,962 

Sundries,  pers.  property,  &c 654,627 

Advance  to  other  companies 1,920,921 

Drawbacks    464,492 

Railroad  mortgage 100,000 

Tannery  plants,  etc 6,847,706 

Stock  of  other  cos 56,760,181 

Bonds  of  other  cos 6,879,888 

Real  estate  interests 490,235 

Treasury  stock    

Good-will,    &c 62,832,300 

Unexpired   insurance 106,293 

Total $169,627,987 

Liabilities : 

Common  stock $62,882,300 

Preferred  stock 62,282,300 

Bonds  less  in  treas 5,080,000 

Accrued  interest,  etc 67,960 

Current    accounts 609,585 

Foreign  exch.  not  due 2,072,904 

Bills   payable 13,080,000 

Miscellaneous    639,729 

Surplus     22,913,209 

Total    $169,627,987 


SOURCES  OF  CORPORATE^  ^UN1)S  101 

$1,420,000.  The  borrowings,  including  bonds,  bills  pay- 
able and  accounts  payable,  are  approximately  $670,000, 
or  something  over  47  per  cent  of  funds. 

To  arrive  at  the  actual  funds  utilized  in  the  property 
of  the  American  Thread  Company  we  should  deduct 
from  the  $19,281,000  assets  the  depreciation  fund  of 
$2,076,000.  Of  the  total  funds,  approximately  $17,- 
200,000,  about  $7,750,000  is  borrowed  (including  bonds, 
debts  to  stock-  and  bond-holders  and  to  English  Sewing 
Cotton  Co.,  and  accounts  payable) .  The  percentage  of 
borrowing  is  45. 

Deducting  reserves  for  depreciation  we  find  funds  of 
the  Bethlehem  Steel  Company  to  be  approximately  $52,- 
500,000.  Borrowings  are  about  $22,000,000  or  42  per 
cent. 

In  the  case  of  A.  Booth  &  Company  there  are  funds 
of  about  $9,750,000  and  borrowings  of  $2,500,000,  or 
25.6  per  cent.  As  the  firm  failed  in  September,  1908, 
this  low  percentage  of  borrowings  tends  to  confirm  what 
has  already  been  said,  to  the  effect  that  abnormally  small 
borrowings  indicate  either  a  weak  or  a  mismanaged  com- 
pany. 

In  estimating  funds  in  the  United  States  Leather 
Company,  we  should,  of  course,  deduct  "good-will." 
It  is  not  improper  also  to  deduct  stocks  and  bonds  of 
other  companies,  all  of  which  were  obtained  in  exchange 
for  preferred  and  common  stock.  This  leaves  actual 
funds  of  approximately  $42,700,000,  against  borrowings 
of  $20,800,000,  about  49  per  cent. 

It  goes  without  saying  that  this  analysis  of  the  five 
balance  sheets  is  superficial  and  that  the  results  are 
merely  suggestive.  To  ascertain  the  exact  proportion 
of  borrowed  to  owned  funds  in  each  case  we  should  have 
first  to  learn  the  exact,  not  the  nominal,  value  bf  the 


lOS!     '      •     *      CdRPORATION  FINANCE 

assets,  which  is  an  impracticable  task.  As  it  is  reason- 
ably certain  that  the  cost  in  every  case  is  less  than  the 
book  value  of  the  assets,  the  true  percentages  of  bor- 
rowed to  owned  funds  are  in  all  probability  greater  than 
the  figures  given.  Four  out  of  these  five  corporations 
no  doubt  borrow  more  than  half  the  funds  they  use.  , 
Other  well-managed  companies  follow  the  same  prin- 
ciple. 

61.  Distribution  of  security  issues. — The  next  ques- 
tion to  consider  is:  What  issues  of  securities  or  credit 
instruments  should  a  corporation  put  out  and  what  pro- 
portion of  its  total  funds  should  be  obtained  by  each  of 
these  issues?  In  order  to  raise  funds  from  each  of  the 
four  sources  outside  the  business  itself  named  above  the 
corporation  manager  will  offer: 

SOURCES  SECURITIES 

(a)  To  trade  creditors  Bills  and  notes  payable 

(b)  To  banks  Notes    payable    and    en- 

dorsed notes  receivable 

(c)  To  the  investing  pub-     Mortgage  bonds  and  per- 

lic  haps  preferred  stock 

(d)  To     the     speculative     Stock. 

public. 

The  amount  of  each  security  offered  will  depend  in  part 
on  the  assets  and  in  part  on  the  earnings  of  the  corpo- 
ration. 

Corporate  assets  in  nearly  every  line  of  business  fall 
naturally  into  six  groups,  as  follows: 

(a)  Fixed  investments  essential  to  the  business,  such 
as  real  estate,  buildings  and  machinery,  and  in  the  case 
of  holding  companies,  securities  of  subsidiary  corpo- 
rations. 


SOURCES  OF  CORPORATE  FUNDS      103 

(b)  Property  that  could  be  sold  without  breaking  up 
the  business,  though  the  sale  would  probably  be  at  a 
heavy  sacrifice,  such  as,  outlying  real  estate,  securities 
of  other  companies  control  of  which  is  not  essential  to 
the  integrity  of  the  corporation,  raw  materials,  and 
goods  in  process. 

(c)  Finished  products  on  hand. 

(d)  Accounts  receivable. 

(e)  Cash. 

(f )  Intangible  assets,  such  as  good-will,  trade  marks, 
etc. 

To  the  first  five  groups  roughly  correspond  obliga- 
tions for  borrowed  money,  as  follows: 

(a)  Mortgages  and  mortgage  bonds  obtainable  as  a 
rule  on  good  terms  up  to  60  to  75  per  cent  of  the  ap- 
praised value  of  real  estate;  50  per  cent  of  buildings; 
25  to  40  per  cent  of  machinery ;  50  to  90  per  cent  of  se- 
curities. 

(b)  and  (c)  Income,  profit-sharing  and  car-trust 
bonds,  on  a  great  variety  of  terms,  preferred  stock  in 
some  cases  and  to  some  extent  short-term  notes  and 
bank  loans. 

(d)  and  (e)   Accounts  payable  and  bank  loans. 

Group  (f )  and  the  diiFerences  between  the  other  as- 
sets and  their  corresponding  liabilities  are  usually  rep- 
resented by  stock  issues  and  by  surpluses.  The  reader 
will  understand,  no  doubt,  that  this  classification  is 
merely  approximate  and  is  not  always  followed  in  prac- 
tice; yet  an  analysis  of  balance  sheets  will  reveal,  on 
the  whole,  a  close  adherence  by  corporation  managers  to 
the  principles  just  stated. 

In  all  industries,  more  or  less,  and  especially  in  rail- 
roads and  stable  manufacturing  concerns,  the  creditors 
of  the  corporation,  as  we  shall  see  later,  pay  mol-e  at- 


104  CORPORATION  FINANCE 

tention  to  the  ineome  account  than  to  the  balance  sheet. 
The  gross  earnings  of  any  corporation  are  necessarily 
devoted  to  the  following  purposes:  (1)  Operation; 
(2)  maintenance;  (3)  fixed  interest  charges  and  rentals; 
(4)  floating  interest  charges;  (5)  betterment  and  sur- 
plus; (6)  dividends. 

The  stability  and  amount  of  the  earnings  will,  of 
course,  greatly  affect — in  fact,  determine  largely — the 
value  of  a  corporation's  assets,  and  in  that  way  will  affect 
the  amount  and  kind  of  securities  that  it  may  wisely 
issue.   ' 


CHAPTER  VIII 

SHORT-TIME  LOANS 

62.  Trade  credit  as  a  source  of  funds, — The  preceding 
chapter  named,  without  describing,  the  three  forms  in 
which  corporations  incur  short-term  or  medium-term  ob- 
ligations, namely,  trade  credit,  bank  loans  and  notes  sold 
to  the  public.  We  will  now  take  up  each  of  these  forms 
in  turn  and  see  what  we  can  discover  as  to  the  principles 
that  should  govern  their  use.  Readers  of  this  volume 
who  are  themselves  engaged  in  an  unincorporated  busi- 
ness will  perhaps  read  what  is  said  as  to  the  first  two 
forms  named  with  a  more  lively  interest  if  they  reflect 
that  the  principles  laid  down  apply  to  partnerships  or 
to  individual  proprietorships  as  well  as  to  corporations. 

The  funds  raised  from  the  trade  creditors  of  a  cor- 
poration are  secured  simply  by  buying  goods  on  credit. 
It  is  not  customary  in  most  lines  of  business  to  demand 
cash  immediately  on  delivery  of  goods,  except  from 
concerns  that  are  considered  untrustworthy.  Thirty 
days  is  usually  allowed  before  trade  creditors  begin  to 
press  for  payment  and  a  company  whose  business  is 
worth  having  can  often  considerably  lengthen  the  av- 
erage time  of  settlement,  if  that  policy  proves  desirable. 
In  some  lines — especially  when  the  sales  are  in  large 
lots — sixty  to  ninety  days,  or  even  six  months,  is  the 
usual  allowance.  For  sixty  days  or  over  the  debtor 
company  generally  gives  a  formal  promissory  note  or 
else  accepts  a  time  draft  which  amounts  to  about  the 
same  thing.  • 

105 


106  CORPORATION  FINANCE 

As  was  indicated  in  Chapter  VII,  it  is  good  business 
policy  for  a  company  to  take  as  much  trade  credit  as  it 
can  get  on  advantageous  terms  and  with  safety.     These 
two  quaHfications  are  worth  elaborating.     A  company 
does  not  obtain  trade  credit  on  advantageous  terms: 
(a)  when  by  so  doing  it  acquires  a  reputation  for  "slow 
pay"  which  makes  dealers  unwilling  to  quote  to  the 
company  their  lowest  prices;  (b)  when  by  so  doing  it 
loses  the  benefit  of  cash  discounts  larger  than  the  pre- 
vailing discount  on  bank  loans, — provided  in  this  case 
that  the  company  is  not  already  borrowing  as  much  as  it 
should  from  banks.     A  company  cannot  accept  trade 
credit  with  safety  when  by  so  doing  its  short-time  lia- 
bilities are  brought  up  nearly  equal  to  its  quick  assets. 
Notice  that  the  relation  is  not  between  total  liabilities 
and  total  assets,  but  between  quick  liabilities  and  quick 
assets.     A  concern  must  have  cash  funds  at  hand  to 
meet  its  accounts  and  bills  payable  when  due  and  no 
other  assets,  no  matter  how  valuable,  will  serve  the  pur- 
pose.    A  failure  to  realize  just  that  simple  fact  has  been 
responsible  for  many  an  unnecessary  bankruptcy. 

Taking  the  five  balance  sheets  previously  referred  to 
(see  pages  98-100) ,  we  find: 

(1)  That  on  the  date  of  the  balance  sheet  the  quick 
liabilities  of  the  Herring-Hall-Marvin  Safe  Company 
were  about  70  per  cent  of  quick  assets  and  about  29  per 
cent  of  all  the  current  assets,  including  stocks,  work  in 
process  and  materials. 

(2)  That  the  corresponding  percentages  for  the 
American  Thread  Company  were  58  per  cent  and  18  per 
cent.  (Current  liabilities,  including  debt  to  English 
Sewing  Cotton  Company,  in  proportion  to  current  as- 
sets, including  stocks,  investments  and  advance  pay- 
ments. ) 


SHORT-TIME  LOANS  lOT 

(3)  That  the  corresponding  percentages  for  the  Beth- 
lehem Steel  Company  were  85  per  cent  and  44  per  cent. 

(4)  That  the  corresponding  percentages  for  A.  Booth 
and  Company  were  83  per  cent  and  64  per  cent. 

(5)  That  the  corresponding  percentages  for  the 
United  States  Leather  Company  were  100  per  cent  and. 
82  per  cent. 

We  may  infer  from  these  five  representative  balance 
sheets  that  a  conservative  company  will  not,  as  a  rule, 
allow  its  accounts,  bills  and  notes  payable  to  run  much 
over  75  to  80  per  cent  of  its  quick  assets.  This  per- 
centage is,  in  fact,  not  far  from  normal.  It  would  be 
foolish  to  try  to  lay  down  any  absolute  rule  where  so 
much  depends  on  the  custom  of  each  line  of  business, 
on  the  seasons,  on  the  nature  of  the  company's  assets,  on 
the  ease  with  which  bank  credit  may  be  secured,  and 
on  the  general  commerical  outlook.  Enough  has  been 
said  to  indicate  that  trade  credit,  though  a  necessity 
to  nearly  every  successful  corporation,  may  become  too 
extensive.  Further  discussion  of  this  important  phase 
of  corporation  finance  must  be  deferred  until  we  begin 
a  study  of  the  financial  management  of  corporations. 

63.  What  reliance  should  be  placed  on  bank  loans? — 
Bank  loans  are  not  usually  to  be  had  except  on  first- 
class  securities  and  for  short  periods.  Perhaps  the  best 
method  of  considering  the  advantages  and  disadvan- 
tages of  bank  loans  will  be  to  run  over  hastily  the  de- 
tailed statements  which  many  conservative  banks  now 
require  applicants  for  loans  to  file  with  them.  A  blank 
form  for  such  statements,  adopted  by  the  New  York 
State  Bankers'  Association,  and  widely  used,  is  pre- 
sented on  pages  108-109.  Let  us  see  how  critically  a 
banker  will  examine  one  of  these  statements  when  pre- 
sented by  a  corporation  with  which  he  is  not  thoroughly; 


108 


CORPORATION  FINANCE 


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SHORT-TIME  LOANS 


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110  CORPORATION  FINANCE 

familiar.  What  is  said  on  this  point  is  largely  based 
on  an  article  by  Mr.  William  Post,  Cashier  of  the 
Central  National  Bank  of  Philadelphia,  in  The  Journal 
of  Accountancy,  Volume  1,  page  181. 

Take  first  the  item,  "notes  receivable."  In  most 
lines  of  business  notes  are  little  given  except  by  weak 
concerns,  and  a  large  amount  of  "notes  receivable"  out- 
standing, therefore,  may  indicate  that  a  corporation  has 
been  in  the  habit  of  granting  unsafe  credits.  Some  of 
the  principal  lines  in  which  note  giving  is  still  common 
are  harvesting  machines,  plumbers'  supplies  and  electric 
trolley  supplies.  Where  notes  are  received  to  any 
considerable  extent  they  are  generally  discounted  at 
once  by  well-managed  corporations.  Corporations 
which  show  a  large  figure  under  this  heading  of  "notes 
receivable,"  therefore,  would  be  regarded  by  the  banker 
with  distrust. 

"Notes  and  accounts  receivable  of  officers,"  except 
in  insignificant  amounts,  would  naturally  arouse  suspi- 
cion. Ordinarily  officers  of  corporations  are  expected 
to  keep  their  personal  obligations  and  the  company 
funds  entirely  separate. 

The  valuation  of  merchandise  should  be  made  by 
means  of  an  expert's  inventory.  In  connection  with 
these  items  a  careful  banker  will  take  into  consideration 
the  possibility  of  extensive  fluctuations  in  value,  partic- 
ularly in  the  case  of  staple  articles  such  as  pig  iron, 
cotton,  wool  and  metal. 

The  other  assets  specified  are  not  of  immediate  in- 
terest to  the  banker,  because  they  will  not  ordinarily  be 
sold  to  meet  short-time  obligations.  They  may  be  con- 
sidered, however,  as  a  final  protection  to  the  banker  in 
case  the  concern  should  go  into  bankruptcy. 

Mr.  Post  suggests,  "that  in  estimating  the  value  of 


SHORT-TIME  LOANS  111 

plants,  a  sharp  distinction  should  be  made  between 
buildings  used  for  manufacturing  and  for  merchandis- 
ing purposes.  A  business  structure,  conveniently 
located  for  trade,  is  a  good  asset.  It  is  not  adapted 
specially  to  any  one  purpose.  Even  if  the  business 
which  now  occupies  it  should  be  withdrawn,  it  could  be 
sold  and  applied  to  some  other  use.  Its  value  can  be 
easily  appraised.  The  banker  is  justified,  therefore,  in 
placing  a  high  net  value  upon  such  property  when  well 
located.  With  the  manufacturing  plant,  however,  the 
situation  is  entirely  different.  The  whole  building  is 
often  specialized  to  some  particular  use:  if  the  busi- 
ness fails  it  is  very  difficult  to  apply  the  premises  to 
other  purposes."  Machinery  is  even  less  salable,  as 
a  rule,  than  a  manufacturing  building.  In  general,  a 
concern  that  is  not  making  a  success  of  its  undertaking 
will  very  seldom  find  buyers,  except  at  a  very  heavy- 
sacrifice,  for  its  fixed  assets. 

Turning  to  the  liabilities,  we  have  already  laid  down 
the  rule  that  "notes  payable"  given  for  merchandise, 
except  in  the  few  lines  of  business  specified  above,  are 
not  required  from  first-class  concerns.  "The  second 
and  third  items,"  says  Mr.  Post,  "are  distinguished  in 
order  to  show  how  much  paper  a  concern  may  have  with 
its  own  banks  and  how  much  it  may  have  negotiated 
through  a  note  broker.  It  is  quite  important  to  the 
banker  to  know  how  much  paper  a  borrower  has  sold, 
as  the  saying  is,  'on  the  street.'  If  he  finds  that  the 
borrower  is  choking  his  bank  account  and  at  the  same 
time  putting  a  large  amount  of  paper  out  into  the  open 
market,  the  banker  is  likely  to  arrive  at  the  conclusion 
that  the  borrower  is  not  keeping  available  any  partic- 
ular resource  of  channel  which  he  could  utilize  in  case  of 
a  stringency  in  the  money  market.     It  is  a  fixed  rule 


11^  CORPORATION  FINANCE 

of  financial  management  that  a  concern  should  not 
borrow  largely  at  its  bank  and  at  the  same  time  sell 
large  amounts  of  its  paper  in  the  market.  If  the  bank 
line  is  full,  paper  should  not  be  upon  the  street ;  if  made 
largely  for  the  street,  then  the  bank  should  be  kept 
open." 

"Accounts  payable"  is  to  be  considered,  of  course,  in 
contrast  to  "accounts  receivable"  and  the  propor- 
tions already  mentioned  in  this  chapter  should  be  ob- 
served. 

Ordinarily  only  close  corporations  would  have  any 
deposits  made  with  them  by  individuals.  Where  there 
are  such  deposits  they  would  be  regarded  as  a  possible 
source  of  danger,  since  the  persons  who  make  them  are 
apt  to  be  in  close  touch  with  the  management  and  to  be 
informed  of  any  impending  trouble  in  time  to  protect 
themselves — possibly  at  the  expense  of  the  other 
creditors. 

Bond  and  mortgage  debts  should,  of  course,  be  pro- 
portioned to  the  fixed  assets  of  the  corporation.  The 
mortgage  should  be  very  carefully  examined  in  order 
to  make  sure  that  it  does  not  cover  more  than  the  fixed 
assets.  Sometimes  a  real  estate  mortgage  wiU  contain 
a  clause  making  it  a  first  lien  also  on  the  chattels  or 
quick  assets  of  the  corporation.  Chattel  mortgages  are 
unusual  and  do  not  often  exist  unless  a  corporation  is 
already  in  serious  straits. 

A  large  amount  of  contingent  liabilities  would  be 
regarded  as  a  weakness.  Especially  is  this  true  of  the 
item  "other  contingent  liability,"  which  refers  to  en- 
dorsement of  outside  paper  and  to  miscellaneous  obhga- 
tions. 

Generally  speaking,  a  corporation  is  not  expected  to 
assign  its   accounts   receivable.     There  may  be   well- 


SHORT-TIME  LOANS  113 

grounded  exceptions  to  this  rule  but  the  exceptions 
require  explanation. 

*^  The  item  "other  assets  used  as  collateral"  would  be 
filled  out  normally  only  by  commission  houses  among 
which  tlie  custom  is  to  put  up  bills  of  lading  or  ware- 
house receipts  as  collateral  for  loans.  In  the  United 
States  a  manufacturing  company  is  not  expected  to 
pledge  any  specific  asset  except  its  fixed  capital.  In 
Canada  and  in  Europe  manufacturers  obtain  funds  from 
banks  upon  pledge  of  raw  material  and  finished  products. 

The  banker  wants  to  be  sure  that  a  corporation  is 
carrying  sufficient  insurance;  otherwise  a  fire  or  some 
other  accident  may  make  the  assets  almost  valueless. 

The  items  under  the  head  "business  and  results"  are 
important,  inasmuch  as  they  tell  the  banker  to  what 
extent  the  company  may  meet  its  obligations  out  of 
income.  An  expert  in  any  particular  business  can  tell 
very  often  by  an  inspection  of  these  items  whether  the 
company  is  well-managed  or  not,  for  he  will  know  how 
large  should  be  the  percentages  of  gross  profits  and 
of  net  profits  to  sales.  It  is  very  difficult  for  an  out- 
sider to  form  any  sound  judgment  on  this  point. 
"Dividends  paid"  will  indicate  how  conservative  the 
corporation  is  in  providing  against  possible  future 
losses.  The  item  of  "bad  debts"  obviously  shows  how 
carefully  the  corporation  looks  after  its  credits. 

The  succeeding  items  are  intended  to  answer  ques- 
tions with  regard  to  the  balance  sheet  or  profit  and  loss 
statement.  The  banker  will,  of  course,  observe  very 
carefully  what  assets  are  covered  by  outstanding 
mortgages  and  bonds.  He  wants  to  know  what  bank 
accounts  are  kept  other  than  those  named  in  the  balance 
sheet,  because  some  concerns  may  keep  additional  secret 
bank  accounts  with  the  idea  of  inducing  the  bankers 

1—8 


114  CORPORATION  FINANCE 

to  favor  them  with  loans.  A  knowledge  of  the  average 
terms  on  which  goods  are  bought  and  sold  enables  the 
banker  to  form  an  idea  as  to  how  pressing  the  corpora- 
tion's accounts  payable  .and  as  to  how  "quick"  its  ac- 
counts receivable  are.  By  learning  the  time  of  year 
when  accounts  receivable,  stocks  of  merchandise  and 
liabilities  are  at  their  maxima  and  minima,  the  banker 
may  better  judge  as  to  whether  the  balance  sheet  repre- 
sents the  normal  condition  of  the  corporation  or  not. 

It  goes  without  saying  that  to  have  the  statement 
based  on  an  actual  inventory  and  to  have  it  audited,  be- 
fore presentation,  by  a  certified  public  accountant,  will 
add  greatly  to  its  value  in  the  eyes  of  any  banker. 

We  have  gone  over  this  blank  form  at  some  length 
for  two  purposes:  First,  because  it  illustrates  how  a 
corporation's  statement  may  be  analyzed  and  how  much 
information  may  be  extracted  from  it;  second,  because 
it  shows  how  strict  and  careful  conservative  bankers 
are  in  granting  loans.  The  writer  does  not  mean  to  say 
that  every  concern  which  borrows  money  from  a  bank 
presents  such  a  detailed  statement  and  has  it  so  closely 
analyzed  as  what  has  been  said  may  indicate.  It  is  true, 
however,  that  the  custom  of  demanding  and  of 
thoroughly  inspecting  such  statements  is  growing.  It 
is  also  true  that  a  conservative  corporation  will  not  desire 
bank  loans  unless  it  can  present  a  statement  that  would 
meet  with  the  approval  of  any  careful  banker. 

64.  Notes  sold  to  the  public  as  a  source  of  funds, — 
Promissory  notes  of  a  corporation  may  be  given  in  order 
to  raise  funds  from  (a)  concerns  which  supply  mer- 
chandise, (b)  banks  or  (c)  the  public.  We  have 
already  seen  how  and  to  what  extent  they  may  be  issued 
in  the  first  two  cases;  we  have  now  to  consider  the  third 
case. 


SHORT-TIME  LOANS  115 

The  form  of  the  note  is  substantially  the  same  in  all 
three  uses.  It  is  a  simple  promise  to  pay  and  must  con- 
tain the  features  that  are  essential  to  all  valid  negotiable 
notes,  which  are:  (a)  two  parties  to  the  contract,  (b) 
transferability,  (c)  a  definite  sum  of  money,  (d)  definite 
day  of  payment,  and  (e)  proper  signature.  It  is  worth 
noting  here  that  as  a  general  rule  the  power  to  bind 
a  corporation  in  this  manner  does  not  belong  to  an 
officer  unless  it  is  expressly  conferred  on  him.  Never- 
theless, the  note  of  a  corporation  signed  and  in  the  hands 
of  an  innocent  holder  for  value  is  usually  binding,  even 
if  the  signer  acted  beyond  his  powers.  Technical  ob- 
jections to  a  note,  based  on  its  improper  execution  or 
on  unauthorized  uses  of  the  money  borrowed,  are  not 
usually  upheld.  It  is  worth  noting  also  that  the  cor- 
poration signature  should  be  used.  Notes  signed  by 
officers  in  their  own  names,  even  if  their  corporate  titles 
are  given,  or  notes  containing  such  words  as  "jointly 
and  severally  promise  to  pay"  may  be  held  as  personal 
obligations. 

The  usual,  although  not  a  necessary,  distinction  be- 
tween notes  given  in  the  ordinary  course  of  trade  or  to 
banks  and  notes  sold  to  the  public  is  in  the  length  of 
time  of  the  debt.  In  the  first-named  cases  they  do  not 
usually  run  over  six  months.  Notes  sold  to  the  public 
are  more  likely  to  run  from  one  to  ten  years.  Two 
or  three  years  is  about  the  average  period,  intermediate 
between  sixty-days  to  six  months  notes,  on  the  one 
hand,  and  ten  to  one-hundred-year  bonds,  on  the  other 
hand.  They  are  issued  in  denominations  varying  from 
$100  to  as  high  as  $100,000. 

The  chief  objection  to  these  instruments  is  that  they 
do  not  appeal  to  any  large  dependable  body  of, pur- 
chasers.    The  commercial  banks  do  not  care  for  them 


116  CORPORATION  FINANCE 

because  they  are  not  "quick"  enough.  Comparatively 
few  individual  investors  will  buy  them  because  they 
are  to  be  cancelled  within  a  comparatively  short  period, 
and  the  average  individual  investor  does  not  choose  to 
watch  his  investments  closely  and  renew  them  fre- 
quently. His  idea,  on  the  contrary,  is  to  get  hold  of 
a  safe  security  that  yields  a  steady  return  and  to  keep 
it  indefinitely.  The  market  for  medium-term  notes, 
therefore,  is  restricted,  generally  speaking,  to  persons 
of  large  means  who  are  in  fairly  close  touch  with  the 
financial  world  and  who  happen  to  have  idle  funds  on 
hand.  Such  persons  are  most  easily  reached  through 
the  big  financial  houses  and  these  houses  almost  invari- 
ably absorb  note  issues  of  any  size  and  distribute  them 
to  their  clients. 

On  account  of  the  limitations  of  the  market  it  is 
always  difficult  to  tell  in  advance  whether  an  issue  of 
medium-term  notes  will  be  taken  up  by  the  public  or 
not.  It  is  still  more  difficult — in  fact,  impossible — to 
tell  at  the  time  of  issue  whether  the  notes  can  be  readily 
renewed  when  the  time  of  payment  arrives.  No  con- 
servative corporation  manager  will  put  out  such  notes 
unless  he  has  first  provided  for  their^^gayment  when 
due.  This  he  may  do  in^two_ways :  either  by  saving  the 
necessary  amount  ouJLuf.  the  corporation's  income  or  by 
securing  through  bondjssues  the  funds  with  which  to 
pay  off  the  notes.  The  first  course  involves  cutting 
down  the  borrowings  of  the  corporation  which,  as  has 
been  pointed  out,  is  likely  to  be  undesirable.  Ordinarily 
the  second  course  would  be  inadvisable,  for  if  bonds 
are  to  be  put  out  at  all  they  might  as  well  be  issued  in 
the  first  place. 

This  suggests  the  usual  reason  for  the  issue  of  notes 


SHORT-TIME  LOANS  lVt\ 

to  the  public,  namely,  as  a  temporary  expeHient  idieBr— 
a  bond  issue  is  for  the  time  being_de£erred.  Some- 
times a  raiiroaSTTsnSuilSing  a  new  branch  or  a  manu- 
faoturing  company  is  putting  up  a  new  building  on 
which  an  issue  of  bonds  is  to  be  based.  In  the  mean- 
time medium-term  notes  may  be  issued  to  secure  funds 
for  construction.  Again,  a  company  in  need  of  funds 
may  find  the  general  financiaLsituat^^  unfavorable  to — 
a  bond  issue  and  may  put  out  notes  with  the  intention 
of  selling  bonds  before  the  notes  come  due.  The  prac- 
tice, though  often  justifiable,  is  always  more  or  less 
risky.  In  April,  1907,  for  instance,  the  Erie  Railroad 
issued,  for  that  reason,  $5,500,000  of  one  year  notes. 
In  April,  1908,  the  conditions  being  still  unfavorable, 
the  railroad  authorized  an  issue  of  $15,000,000  three 
year  notes,  of  which  $5,500,000  were  exchanged  at  par 
for  the  first  issue.  In  July,  1907,  the  Bethlehem  Steel 
Company  issued  $1,187,000  of  6  per  cent  serial  three, 
four,  and  five  year  notes,  apparently  for  the  same 
reason.  In  October,  1906,  the  American  Locomotive 
Company  issued  $5,000,000  of  one  to  five  year  notes 
for  the  purpose  of  paying  floating  indebtedness  and  of 
providing  working  capital.  It  is  expected  that  these 
notes  will  be  redeemed  out  of  income.  These  examples 
will  indicate  roughly  when  and  how  medium-term  notes 
are  issued. 

Although  not^  f or  the  publjc  are  generally  simply 
unsecured  promises  to  jpay^they  may,  especially  for  the 
longer  terms,  be  based  on  certain  definite  property.  A 
corporation's  holdings  of  securities  of  other  companies 
are  frequently  put  up  under  mortgage  as  collateral 
security.  It  is  difficult  to  draw  a  line  between  long- 
time  collateral   trust   notes   and   short-time   collateral 


118  CORPORATION  FINANCE 

trust  bonds;  in  fact,  notes^and  bonds  mer^e  into^ach_ 
other  and  the  distinction  between  them  is  in  some  cases 
merely  nominal. 

In  this  chapter  we  have  been  dealing  with  the  current 


obligations  ^f  corporations.  The  main  point  with  re- 
gard  to  them  to  bear  in  mind  is  that  they  ought  to  be 
offset,  if  they  are  to  be  made  good,  by  a  more  than 
equal  amount  of  current  assets,  and  no  other  kind  of 
assets  will  serve  the  purpose.  To  issue  notes  and  put^ 
the  funds  thus  secured  into  fixed  or  semi-fixed  ^ssets^ 
without  having  on  hand  a  large  surplus  of  current 
assets  is  unsound  and  dangerous  financings 


CHAPTER  IX 

THE  CORPORATE  MORTGAGE 

65.  What  determines  the  value  of  ficced  assets? — 
Now  we  take  up  the  long-time  obligations — especially 
mortgages  and  mortgage  bonds — of  corporations.  Evi- 
dently they  must  be  based  on  permanent,  or  fixed  assets, 
and  in  amount  will  correspond  roughly  to  the  value  of 
such  assets. 

Here  we  meet  with  the  difficult  and  important 
question.  What  determines  the  value  of  fixed  assets? 
Most  people  would  be  inclined  to  say  that  the  cost  of  the 
assets  must  determine  their  value.  A  moment's  reflec- 
tion, however,  shows  this  statement  to  be  untrue. 
Suppose,  for  instance,  that  a  man  has  put  up  a  plant  at 
an  expense  of  $100,000  for  refining  copper,  and  after- 
wards discovers  that  there  is  no  copper  within  hauling 
distance.  The  plant  would  not  be  worth  the  expense  of 
demolishing  it.  On  the  other  hand,  suppose  that  he 
does  put  his  plant  in  a  rich  copper  country  and  secures 
such  favorable  contracts  with  the  mine  owners  that  he 
makes  profits  of  $100,000  a  year  and  may  expect  to  con- 
tinue such  profits  for  an  indefinite  period.  His  plant, 
in  that  case,  could  be  sold  for  perhaps  a  million  dollars. 
Evidently  cost  of  construction  would  have  very  little  to 
do  with  the  value  of  such  assets. 

The  second  opinion  is  that  the  value  of  fixed  assets 
is  determined  by  the  expense  of  duplicating  them.  It 
is  claimed,  for  instance,  that  to  arrive  at  a  fair  valuation 
of  the  railroad  property  of  the  United  States,  all  we 

119 


120  CORPORATION  FINANCE 

need  to  do  is  to  figure  how  much  it  would  cost  to  re- 
produce this  property  under  present  conditions.  The 
illustration  already  used,  however,  would  apply  in 
criticism  of  this  second  opinion  as  well. 

The  third  opinion  is  that  the  value  of  fixed  assets  is 
determined  by  their  earning  power  as  in  the  above 
illustration.  It  takes  no  argument  to  show  that  this  is 
actually  the  case  in  ordinary  business  practice.  If  you 
were  going  to  buy  anything  in  the  nature  of  a  fixed 
asset,  from  a  university  education  to  a  steel  mill,  your 
first  question  as  a  business  man  would  be.  How  much 
will  this  asset  earn  for  me?  Similarly,  an  investor  in 
buying  the  securities  of  a  corporation  will  inquire  as 
to  the  value  of  the  corporation's  ^^edU^ssets,  and  will 
naturally^estimate^^eir  value  onjhe^asis  of_earnin^gs=:7- 
not  the  present  earnings  altogether,  but  probable  future, 
earnings 'a^~well. 

l^ear  in  mind  that  this  principle  that  earnings  de- 
termine value  is  applicable  only  to  fixed  assets.  The 
selling  value  of  floating  assets,  such  as  raw  material, 
tools,  finished  goods  on  hand,  is  another  matter.  That 
will  be  determined,  normally,  as  the  science  of  economics 
explains^y  cost  of  production.  The  difi*erence  arises 
from  the  fact  that  fixed  assets — land,  buildings, 
machinery — are  not  intended  for  sale,  but  for  use. 
They  generally  have  little  or  no  value  except  for  the 
purpose  for  which  they  were  intended;  and  their  value 
for  their  purpose  can  be  determined  only  by  their 
earning  power. 

We  have  already  intimated  without  going  into  details 
that  the  amount  of  investors'  securities  which  may  be 
issued  by  any  corporation  depends  both  on  the  value 
of  its  fixed  assets  and  on  the  amount  of  its  income 
available  for  interest  charges.     There  is  no  contradic- 


THE  CORPORATE  MORTGAGE       121 

tion  between  these  two  considerations.  At  bottom  the 
important  jactor  on  which  to  base  bond^issues  of  a  going 
concern  js^  the_  amount  and  stability  of  income.  We 
shall  elaborate  and  emphasize  this  point  a  little  later. 

66.  Nature  of  a  mortgage  bond, — The  simplest 
method  and  the  method  most  common  among  small  cor- 
porations of  borrowing  long-time  funds  is  by  direct 
mortgage  on  the  corporation's  real  property.  An 
ordinary  mortgage  conveys  "all  right,  title  and  interest" 
in  a  given  piece  of  property  to  the  mortgagee,  with  the 
proviso  that  the  transfer  is  to  become  null  and  void  in 
case  principal  and  interest  are  paid  as  promised.  Al- 
though the  old  common-law  phrases,  which  would  cause 
the  whole  property  mortgaged  to  pass  to  the  mortgagee 
in  case  of  default,  are  generally  retained  in  the  mort- 
gage indenture,  yet  the  mortgage  is  universally  re- 
garded at  law  as  in  effect  a  lien.  A  simple  corporate 
mortgage  is  in  no  important  respect  diiFerent  from  a 
mortgage  by  an  individual  or  firm. 

Where  large  sums  of  money  are  to  be  raised  by  a 
mortgage,  however,  the  procedure  is  not  quite  so  simple. 
In  such  a  case  it  is  customary  to  offer  mortgage  bonds 
in  convenient  denominations  to  the  public.  As  the 
property  mortgaged  is  for  all  practical  purposes  in- 
divisible and  as  there  are  a  large  number  of  secured 
bondholders,  it  is  impracticable  to  give  a  separate 
mortgage  with  each  bond.  It  becomes  necessary, 
therefore,  to  give  the  mortgage  to  some  individual  or 
concern,  acting  as  trustee  for  the  bondholders,  in.  which 
case  the  mortgage  indenture  becomes  a  deed  of  trust. 
Each  bond  is  a  simple  promise  to  pay,  its  phrasing  being 
more  formal,  however,  than  that  of  a  note.  It  is 
executed  under  corporate  seal  and  contains  a  reference 
to   the    indenture    between   the    corporation    and    the 


122  CORPORATION  FINANCE 

trustee.  A  study  of  the  sample  mortgage  bond  printed 
on  page  123,  will  serve  better  than  a  long  description 
to  show  the  reader  exactly  what  is  contained  in  a  bond. 

The  varieties  of  mortgage  bonds  will  be  considered 
later.  For  the  present  let  us  take  up  the  terms  of  the 
deed  of  trust  between  the  corporation  and  the  trustee. 

67.  Essential  features  of  a  deed  of  trust, — Experience 
has  demonstrated  the  necessity  of  making  this  deed 
very  exact  and  comprehensive.  The  indenture  of  a 
large  railroad  mortgage  may  contain  as  many  as  50,000 
to  100,000  words.  If  printed  and  bound  it  would 
make  a  good-sized  book.  Of  course,  the  ordinary  in- 
dustrial corporation  would  not  find  so  lengthy  and 
involved  a  description  of  the  property  and  the  terms 
of  the  mortgage  necessary.  To  the  lay  reader  even  a 
comparatively  simple  indenture  is  apt  to  seem  a  mass  of 
cumbersome  and  more  or  less  nonsensical  legal  j)hrase- 
ology;  but  it  must  be  borne  in  mind  that  every  such 
deed  is  closely  scanned  by  a  large  number  of  able  and 
experienced  lawyers,  who  will  demand  that  no  possible 
loophole  for  evasion  or  misinterpretation  shall  be  left 
open.  The  rights  and  obligations  of  each  of  the  three 
parties  to  the  agreement,  the  corporation,  the  bond- 
holder and  the  trustee,  must  be  fully  and  explicitly  set 
forth  and  the  mortgaged  property  must  be  described  so 
exactly  that  no  conflict  with  other  mortgages  or  obliga- 
tions can  possibly  arise.  The  instruments  have  now 
come  to  follow  certain  models  and  are  almost  always 
arranged  about  as  follows: 

First,  of  course,  come  the  date  and  the  names  of  the 
parties  to  the  indenture.  Next  follows  the  preamble, 
in  which  is  a  full  statement  of  the  legal  status  of  the 
corporation,  including  the  state  in  which  it  is  incorpo- 
rated, the  amount  of  its  capital  stock  ^nd  bonds,  the 


THE  CORPORATE  MORTGAGE 


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amount  and  kind  of  property  it  owns.  The  preamble 
also  presents  the  authority  given  by  the  stockholders  and 
directors  for  the  bond  issue  and  the  specific  purpose  of 
the  issue.  Then  the  full  texts  of  the  bond,  the  interest 
coupon,  if  it  is  a  coupon  bond,  and  the  trustees'  cer- 
tificate of  validity,  which  should  appear  on  each  bond 
(see  form  on  page  123),  are  given. 

The  granting  clause,  which  transfers  the  property 
to  the  trustee,  and  a  detailed  description  of  the  mort- 
gaged property  follow.  The  duties  of  the  trustee,  in- 
cluding the  statement  that  the  property  is  granted  only 
in  trust,  and  a  provision  that  the  trustee  shall  certify 
to  the  validity  of  each  bond  are  next  set  forth.  This 
is  followed  by  the  covenant  of  the  corporation  to  pay 
the  interest  and  principal  of  the  bonds  at  the  time 
specified. 

An  important  section  of  the  mortgage  is  that  which 
binds  the  corporation  to  keep  the  property  insured,  pay 
all  taxes,  assessments  and  charges,  and  in  general  to 
preserve  the  property  and  keep  the  lien  valid.  Another 
section  retains  for  the  company  complete  control  of  the 
mortgaged  property  and  enjoyment  of  all  the  profits 
unless  and  until  default  is  made  of  principal  or  interest. 

Where  a  corporation  has  subsidiary  companies  it  may 
be  necessary  to  include  a  full  statement  as  to  the  status 
and  securities  of  each  of  these  companies. 

The  sections  following  deal  with  default  and  fore- 
closures. Exactly  what  constitutes  default  must  be 
definitely  stated.  Usually  a  short  period  of  grace  is 
allowed  after  interest  payments  fall  due  before  the 
trustee  can  take  action.  The  percentage  of  bond- 
holders at  whose  request  the  trustee  shall  take  active 
steps  is  stated,  usually  20  or  25  per  cent.  The  per- 
centage of  bondholders  who  must  request  foreclosure 


THE  CORPORATE  MORTGAGE       125 

and  sale  in  order  to  authorize  the  trustee  to  proceed 
to  this  extent  is  also  given;  usually  a  majority  is  re- 
quired. The  course  of  action  of  the  trustee  in  case  of 
foreclosure  and  sale  is  prescribed  and  the  proceedings 
in  case  of  receivership  are  set  forth. 

The  responsibilities,  liabilities  and  compensation  of  the 
trustee  are  presented  and  provision  is  made  for  the  res- 
ignation of  the  trustee,  or  his  removal  upon  request  of  a 
majority  of  the  bondholders,  and  for  the  appointment  of 
his  successor. 

It  is  customary,  although  seemingly  hardly  necessary, 
to  absolve  the  officers  and  directors  of  the  corporation 
from  any  personal  liability. 

In  long  mortgages  there  is  frequently  a  separate  sec- 
tion in  which  terms  and  phrases  used  in  the  indenture  and 
open  to  possible  misinterpretation  are  exactly  defined. 

At  the  end  appear  the  signatures  and  seals  of  the  cor- 
poration and  of  the  trustee  through  their  proper  officers 
with  formal  attestation  of  the  seals. 

Frequently  modifications  of  the  original  document  are 
called  for  by  changes  in  the  legal  status  of  the  corpora- 
tion or  trustee  or  in  the  corporate  property.  Such  modi- 
fications may  take  the  form  either  of  a  supplementary 
indenture  or  of  a  supplementary  agreement.  The  latter 
is  less  formal  and  usually  relates  to  comparatively  unim- 
portant matters.  Supplementary  indentures  are  most 
common  in  case  of  reorganization.  They  must  be  au- 
thorized by  stockholders  and  bondholders  as  well  as  by 
the  two  parties  directly  concerned. 

68.  Classification  of  mortgage  deeds  of  trust, — Mort- 
gages are  conveniently  classified  as  closed,  open-end,  and 
limited  open-end.  A  closed  mortgage  covers  a  limited 
amount  of  bonds  all  issued  at  one  and  the  same  time  and 
absolutely  forbids  any  additional  bonds  secured  by  the 


U6  CORPORATION  FINANCE 

same  mortgage.  The  open-end  mortgage  authorizes  an 
indefinite  amount  of  bonds,  some  of  which  are  issued  at 
once  and  some,  under  certain  restrictions,  in  the  future. 
This  type  has  so  far  been  restricted  to  railroad  com- 
panies. The  usual  provision  is  that  a  given  amount  of 
additional  bonds  may  be  issued  for  each  additional  mile 
of  track  constructed. 

The  limited  open-end  mortgage,  which  is  the  common 
and  for  almost  all  purposes  the  best  type,  names  a  certain 
maximum  amount  of  bonds  to  be  based  on  the  mortgage, 
part  of  which  amount  is  issued  at  once.  The  rest  may 
be  sold  under  certain  restrictions  as  to  time;  usually  a 
given  amount  may  be  put  out  each  year.  Sometimes 
there  are  further  restrictions,  such  as  a  requirement  for 
the  permission  of  the  syndicate  which  bought  the  first 
installment ;  or  the  requirement  that  interest  on  outstand- 
ing bonds  be  paid  for  a  given  period  before  any  new 
bonds  are  sold. 

The  merits  of  this  limited  open-end  mortgage  over 
either  of  the  other  two  types  are  obvious.  An  abso- 
lutely closed  mortgage  may  make  it  very  difficult  for  a 
corporation  to  secure  additional  funds  with  which  to 
carry  on  construction  that  is  essential  to  its  welfare. 
Possibly  the  corporation's  earnings  may  thereby  be  re- 
stricted so  as  to  invalidate  the  bondholders'  as  well  as 
the  stockholders'  interests.  The  6pen-end  mortgage,  on 
the  other  hand,  is  too  indefinite.  The  corporation  may 
issue  so  many  bonds  under  the  mortgage  and  may  raise 
its  fixed  charges  to  so  high  a  point  as  to  bring  risk  or 
even  actual  loss  to  the  bondlioWers.  We  must  not  for- 
get in  dealing  with  mortgages  and  mortgage  bonds  that 
in  principle  the  holders  of  these  instruments  are  supposed 
to  be  free  from  even  reasonable  risk. 


CHAPTER  X 

TYPES  OF  CORPORATION  BONDS 

69.  Classification  of  bonds, — This  and  the  following 
chapter  are  devoted  to  enumerating  and  describing  the 
various  types  of  bonds  that  are  in  common  use.  We 
would  recommend  that  they  be  studied  with  particular 
care;  for  ignorance  as  to  the  exact  nature  and  uses  of 
each  of  the  bond  types  named  may  very  easily  prove 
costly  both  to  investors  and  to  corporations.  An  error 
that  is  particularly  frequent  in  small  manufacturing  cor- 
porations is  to  create  a  bond  issue  of  a  type  that  is  not  at 
all  adapted  to  the  financial  status  and  prospects  of  the 
corporation.  One  attentive  reading  of  these  two  chap- 
ters would  have  prevented  many  of  these  errors. 

Bonds  may  be  classified  with  respect  to : 

(a)  The  security  for  their  payment, 

(b)  Their  purposes, 

(c)  The  manner  of  their  payment, 

(d)  The  conditions  of  their  redemption. 

As  these  classifications,  which  should  be  kept  quite  dis- 
tinct, are  frequently  confused,  the  writer  has  made  up 
the  following  list  of  the  words  commonly  used  in  de- 
scribing bonds,  each  word  being  placed  under  its  proper 
heading : 

A. — Security  of  Bonds. 

1.  First  Mortgage, 

2.  Second  Mortgage,  Third  Mortgage,  etc. 

127 


128  CORPORATION  FINANCE 

3.  Terminal,  Divisional,  Land-Grant,  or  other  Spe- 

cial Mortgage, 

4.  General  Mortgage, 

5.  Sinking-fund, 

6.  Collateral  Trust, 

7.  Car  or  Equipment  Trust, 

8.  Debenture, 

9.  Income, 

10.  Participating, 

11.  Profit-Sharing, 

12.  Joint, 

13.  Receivers'  Certificates. 

B. — Purposes  of  Bonds, 

1.  Unifying, 

2.  Refunding, 

3.  Construction, 

4.  Purchase-Money, 

5.  Improvement, 

6.  Extension, 

7.  Adjustment, 

8.  Consolidated. 

C. — Manner  of  Payment. 

1.  Coupon, 

2.  Registered, 

3.  Registered  as  to  principal,  but  dividends  in  cou- 

pon  form. 

D. — Conditions  of  Redemption. 

1.  Gold, 

2.  Redeemable, 

3.  Serial, 

4.  Convertible. 


TYPES  OF  CORPORATION  BONDS  129 

70.  Mortgage  Bonds, — A  bond  secured  by  a  first 
mortgage  on  all  the  real  property  of  a  corporation — 
provided  the  corporation  is  stable  and  prosperous  and 
the  bond  issue  is  not  large — is  regarded  as  a  highly  de- 
sirable investment.  You  could  infer  this  from  the  quo- 
tations on  the  first  mortgage  bonds  of  the  standard  rail- 
roads and  industrial  companies,  as  shown  in  the  three 
examples  below.  It  should  be  noted  that  none  of  these 
three  issues  is  secured  by  an  absolute  first  mortgage. 
Such  issues  are  usually  small  and  thei^  prices  are  hard  to 
determine. 

In  March,  1909,  Baltimore  &  Ohio  first  4's  sold  to 
yield  4.05  per  cent;  Western  Union  first  4's,  to  yield 
4.45  per  cent;  Union  Pacific  first  4's,  to  yield  4.02  per 
cent. 

A  debt  secured  by  a  bona  fide  first  mortgage  cannot 
be  interfered  with  by  any  inferior  security  and,  unless 
the  corporation  goes  into  receivers'  hands,  no  security 
of  higher  rank  can  be  put  out. 

It  is  always  possible,  of  course,  to  place  a  second  mort- 
gage on  the  same  property  covered  by  the  first  mortgage 
and  to  follow  the  second  mortgage  by  a  third,  and  a 
fourth,  and  so  on.  It  is  very  seldom  possible,  however, 
to  find  buyers  for  anything  junior  to  a  second  mortgage 
bond.  Although  bonds,  as  we  have  seen,  are  really  se- 
cured by  income,  yet  as  they  are  nominally  based  on 
property,  investors  do  not  like  junior  bonds.  Their  dis- 
like is  not  unreasonable,  for  in  case  of  reorganization 
the  heaviest  loss  would  necessarily  fall  on  the  holders 
of  junior  securities.  Many  large  corporations  have 
made  every  effort  to  give  each  one  of  their  bond  issues, 
no  matter  how  numerous  these  issues  may  be,  the  ap- 
pearance of  being  based  on  a  first  mortgage.     To  this 

1—9 


130  CORPORATION  FINANCE 

end  many  ingenious  expedients  and  names  have  been  in- 
vented. 

For  instance,  there  are  many  railroad  divisional  and 
terminal  first  mortgage  bonds.  Sometimes  these  bonds 
are  based  on  property  highly  valuable  in  itself.  Some- 
times, however,  they  are  first  mortgages  on  branch  lines 
or  on  terminal  realestate  that  would  be  of  very  littlejise 
to  any  concern  except  the  particular  railroad  that  issues 
the  bonds.  In  such  a  case  the  vaunted  priority  of  the  di- 
visional or  terminal  bond  is  more  or  less  of  a  fiction.  A 
railroad  could  give  up  the  branch  line  or  the  terminal 
real  estate  far  more  easily  than  the  bondholders  could 
afford  to  have  the  property  separated  from  the  railroad. 

Another  very  common  practice  with  both  railroads  and 
industrials  is  to  have  first  mortgage  bonds  issued  by  sub- 
sidiary companies  and  then  have  a  nominal  first  mort- 
gage bond  issued  by  the  holding  company.  The  hold- 
ing company's  bond  is  in  reality  based  only  on  its  hold- 
ings of  subsidiary  companies'  securities  and  is  inferior  to 
all  the  subsidiary  company  bonds.  Various  names  are 
given  to  these  junior  issues.  Sometimes  they  are  called 
"first  and  refunding"  mortgage  bonds,  or  "first^neral" 
mortgag^lBonds,  or  "first  and^  unifying."  The  words 
"unifying,"  "consolidated,"  "refunding,"  and  the  like, 
used  in  this  connection,  are  intended  to  signify  that  the 
underlying  bonds  will  be  retired  as  they  fall  due  with  the 
proceeds  of  the  new  issue.  It  would  perhaps  not  be  just 
to  say  that  these  names  are  intended  to  mislead;  but  at 
least  it  may  be  said  that  they  put  the  most  favorable  pos- 
sible construction  on  the  terms  under  which  the  bonds  are 
issued. 

71.  Sinking  fund  bonds. — In  the  case  of  mines  and 

other  enterprises  which  have  a  pretty  definitejease  of 

^Jife^it  is  necessary  for  the  protection  of  bondholders  to 


TYPES  OF  CORPORATION  BONDS      131 

establish  a^inkin^^und  forjt^^  of  mortgage 

bonds^  In  such  cases  the  sinking  fund  is  frequently 
obtained  by^etting^;Side_a  certain  portion  of  the  com- 
pany's income.  Lumber  companies  sometimes  reserve 
a  certaiiTamount  of  each  thousand  feet  of  lumber  cut  and 
coal  mining  companies  a  certain  amount  of  each  ton  of 
coal  mined.  It  is  more  common,  however,  to  set  aside 
a  fixed  amount  each  year. 

There  are  tjireemethods  of  estimating  the  amount  that 
should  be  set  aside  each  year.  One  method  is  to  divide_ 
the  amount  of  the  debt  by  the  number  of^^ars  that  the 
debt  runs  and  put  into  the  fund  each  year  the  resulting 
amount.  This  is  simple  enough,  but  decidedly  crude. 
As  no  account  is  taken  of  interest  on  the  sums  in  the 
fund,  the  method  ties  up  an  unnecessarily  large  amount 
of  money.  ;*r:The^econd  method  allows  whatever  is  put 
into  the  fund  to  accumulate  at  compound  interest  and 
therefore  calls  for  a  much  smaller  annual  payment  than 
the  preceding  method.  The  third  method  is  what  is 
known  as  the  mstallment  or  animjfejmethod  and  con- 
sists in  paying  egual  periodic  installments  to  the  bond- 
holders, or  their  trustee,  to  settle  principal  and  interest^ 
in  a  given  number  of  years.  It  calls  for  somewhat 
larger  payments  than  the  second  method,  inasmuch  as  it 
takes  care  not  only  of  the  principal,  but  of  the  interest 
as  well.  A  fuller  discussion  of  sinking  fund  methods  is 
contained  in  the  volume  on  Theory  and  Practice  of 
Accounting. 

The  sinking  fund  method  of  guaranteeing  that  bond 
issues  will  be  paid  has  been  much  used  by  industrial  cor- 
porations, particularly  when  the  permanence  of  their 
business  is  somewhat  uncertain  and  investors  conse- 
quently are  inclined  to  look  upon  their  securities  with 
suspicion.     In  such  a  case  it  may  be  an  advisable  ar- 


132  CORPORATION  FINANCE 

rangement  both  for  the  corporation  and  for  the  bond- 
holders. Where  the  corporation's  assets,  however,  are 
of  a  permanent  nature,  the  sinking  fund  is  no  longer  re- 
garded with  favor.  The  objections  to  its  use  are  clearly 
stated  in  the  following  selection  from  Professor  E.  S. 
Meade's  "Trust  Finance." 

The  sinking  fund  is  of  no  benefit  to  the  stockholder  otHer 
than  to  ultimately  decrease  the  liabilities  of  the  company.  Dur- 
ing a  long  period,  however,  the  corporation  is  under  the  neces- 
sity of  paying  interest,  and  at  the  same  time  of  contributing  to 
the  sinking  fund.  The  result  of  this  double  contribution  is,  for 
perhaps  twenty-five  years,  to  compel  the  stockholder  to  pay 
double  for  the  money  borrowed.  The  amount  available  for  divi- 
dends is,  therefore,  reduced,  and  the  stockholder  suffers. 

It  may  be  argued  that  the  stockholder  will  eventually  receive 
full  compensation  for  these  smaller  dividends  in  the  reduction  of 
fixed  charges  which  the  sinking  fund  will  eventually  bring  about ; 
but  aside  from  the  fact  that  it  is  a  hardship  for  him  to  wait  so 
long  for  this  reward,  there  is  the  further  objection  that  even 
after  the  reduction  of  liabilities  by  the  cancellation  of  the  bond 
principal,  the  owners  of  the  company  will  have  made,  averaging 
the  periods  before  and  after  the  retirement  of  the  bonds,  smaller 
profits  than  if  no  sinking  fund  had  been  gathered.  The  reason 
for  this  permanent  reduction  of  profits  by  the  collection  of  a 
sinking  fund  is  as  follows:^  A  sinking  fund  must  be  invested  in 
securities.  It  cannot  be  put  into  betterments.  In  the  form  in 
which  it  is  accumulated,  a  low  rate  of  interest  from  the  invest- 
ment of  these  annual  sums  is  all  that  can  be  expected.  The 
compounding  of  these  annual  investments,  it  is  supposed,  equals 
the  principal  of  the  bonds  at  the  time  of  maturity,  and  the  cor- 
poration is  thereafter  freed  from  a  portion  of  its  fixed  charges. 
This  gain,  however,  is  in  reality  a  loss  to  the  stockholders.  If 
the  money  which  has  gone  into  the  sinking  fund  had  been  spent 
upon  improving  the  property,  the  stockholders  wouldjeyentually 
have  received  a  larger  dividend.. 


TYPES  OF  CORPORATION  BONDS  133 

It  may  be  assumed  that  the  corporation  can  earn  a  higher  re- 
turn on  money  invested  in  improving  its  own  property  than  the 
return  on  securities  purchased  for  the  sinking  fund.  Under 
these  circumstances,  it  is  a  good  policy  to  devote  all  surplus 
funds  to  increasing  the  earning  power  of  the  company,  allowing 
the  debt  to  run  without  a  special  provision  for  repayment.  In 
other  words,  by  refunding  bonds  when  they  mature,  and  by  re- 
fusing to  make  any  deductions  from  profits  to  provide  funds  for 
debt  payment,  a  corporation  not  only  pays  a  larger  dividend,  but 
increases  the  value  of  its  productive  assets  more  rapidly  than  the 
value  of  its  sinking  fund  would  increase  during  an  equal  number 
of  years.  To  put  the  matter  in  still  another  way,  the  accumula- 
tion of  a  sinking  fund  by  a  corporation  decreases  the  propor- 
tion of  debt  to  value  of  property  less  rapidly  than  when  the 
annual  amount  of  the  sinking  fund  is  invested  in  the  equipment.^ 

For  the  larger  corporations  the  sinking  fund  is  usually 
in  charge  of  a  special  trustee  acting  for  the  bondholders. 
With  smaller  corporations,  however,  it  is  customary  to 
allow  the  sinking  fund  to  remain  in  the  custody  of  the 
corporation. 

72.  Collateral  trust  bonds. — ^With  the  growth  of  large 
holding  companies  a  modified  form  of  mortgage  bond 
has  come  to  be  widely  used.  It  is  called  a  "collateral 
trust"  bond  because  it  is  based  onthe  securities  of  other 
companies  owned  by  the  bond-issuing  corporation  and 
deposited  with  a  trustee  as  collateral  security  for  the 
bondKoTdefs.  The  securities  are  covered  by  a  deed  of 
trust  just  as  in  the  case  of  real  property  offered  as  se- 
curity. The  securities  may  consist  either  of  stocksj)r  of 
bonds  of  subsidiary  companies  or  of  a  combination  of 
both!  ~^  ^ 

It  would  seem  at  first  sight  that  a  collateral  trust  bond 
would  not  be  worth  much,  especially  when  the  collateral 

1  Truit  Finance,  pp.  241-24-3. 


134  CORPORATION  FINANCE 

consists  of  stock.  In  such  a  case  the  collateral  trust 
bond  would  be  junior  by  several  degrees  to  all  underly- 
ing bonds  of  the  subsidiary  companies.  In  case  any  of 
the  subsidiary  companies  go  into  bankruptcy  and  force 
the  holding  company  to  default,  all  that  the  trustee  for 
the  collateral  trust  bondholders  can  do  is  to  take  the 
stock  posted  as  collateral.  When  he  gets  the  stock  he 
still  is  a  long  distance  from  having  tangible  property 
with  which  to  satisfy  the  demands  of  the  bondholders. 
Even  when  the  collateral  condsts  of  bonds  they  are  usu- 
ally junior  issues  and  the  collateral  trust  bondholders  in 
case  of  default  are  very  uncertain  as  to  getting  posses- 
sion of  real  property. 

Nevertheless,  collateral  trust  bonds  are  sold  at  high 
prices.  The  Northern  Pacific-Great  Northern  collateral 
trust  4's,  which  are  secured  by  the  deposit  of  Chicago, 
Burlington  &  Quincy  Railroad  Company  stock,  were 
selling  close  to  par  in  1909.  Many  other  similar  issues 
are  well  thought  of  in  the  financial  district.  One  reason 
is  that  the  income,  out  of  which  interest  on  the  collateral 
trust  bonds  is  paid,  is  derived  from  the  interest  and  divi^ 
dends  on  the  collateral,  and  these  latter  returns  are  more 
regular  than  are  railroad  or  industrial  profits.  A  second 
reason  is  that  securities,  if  they  are  worth  anything  at  all, 
are  almost  always  readily  salable,  whereas  real  property, 
even  if  its  cost  and  value  are  high,  is  apt  to  prove  un- 
marketable. Hence,  the  collateral  trust  bonds  have 
great  advantages  in  these  respects  which  in  the  eyes  of 
the  financial  public  often  outweigh  their  obvious  disad- 
vantages. 

Strange  as  it  may  seem,  it  is  not  impossible  for  a  hold- 
ing company  with  subsidiaries,  whose  credit  is  poor,  to 
take  the  stocks  and  bonds  of  these  companies,  post  them 
as  collateral  and  sell  the  collateral  trust  bonds  very  read- 


TYPES  OF  CORPORATION  BONDS      135 

ily.  It  is  not  unnatural  to  feel  a  passing  doubt  as  to  the 
sanity  of  the  financial  world  when  one  discovers  that  a 
promise  to  pay  based  on  real  property  is  less  valuable 
than  a  promise  to  pay  based  on  paper  that  is  itself  based 
on  the  same  real  property.  Yet  after  all  there  is  a  sound 
reason  for  this  apparent  absurdity.  Reaj^  property  is^ 
hard  to  sell;  paper  representatives  of  property  may  be 
easily  soFd.^  Collateral  trust  bonds  are  therefore  fre- 
quently excellent  means  of  raising  funds  forjubsidiary 
cgmpaniesjvith^^  of  their^wn. 

They  are  also  very  useful  at  times  in  financing  the 
process  of  buying  control  of  subsidiary  companies.  The 
holding  company  borrows_mpney  from  the  banks  and 
buy^  securities;  then  it  issues  collateral  trust  bonds  based 
on  these  securities  and  with  the  funds  thus  obtained  pays 


oiF  the  bank  Joans.  Thus  it  finds  itself  with  very  little 
expenditure  of  its  own  funds  in  full  control  of  the  com- 
pany whose  stocks  it  has  bought.  Some  companies  have 
repeated  this  simple  process  time  and  time  again.  It  is 
entirely  legitimate,  though  somewhat  risky. 

To  protect  the  bondholders,  collateral  trust  mort- 
gages generally  provide  against  the  issue  of  any  securi- 
ties by  subsidiary  companies  ahead  of  those  deposited  as 
collateral.  The  mortgages  also  frequently  have  clauses 
to  prevent  unfavorable  leases  or  other  misuse  of  property 
represented  by  the  deposited  securities. 

A  further  study  of  this  type  of  bond  belongs  in  the 

subject  of  investments  rather  than  here.     Enough  has 

been  said  to  indicate  how  a  holding  company  may,  _by^ 

^eans  of  collateral  trust  bonds,  borrow  funds  which  it__ 

^would  probably~be  impossible  ^forthejiubsidiary  comr, 

gardes  to  reach.  ~~ 

73.  Equipment  trust  bonds. — This  form  of  bond  is 
not  used  to  any  extent  by  other  than  railroad  companies. 


136  CORPORATION  FINANCE 

The  equipment  used  as  security  for  a  bond  issue  of  this 
kind  does  not  belong  to  the  railroad  company  at  all. 
The  manufacturers  of  the  equipment  usually  turn  it 
over  to  an  intermediary  company,  which  in  turn  leases  it 
to^the  railroad,  generally  for  a  term  of  ten  years  or  less, 
and  hands  over  the  lease  to  the  trustee  of  the  equipment- 
t^ist  bondholders.  The  railroad  pays  to  the  trustee  the 
purchase  price  of  the  equipment  in  equal  installments,  to- 
gether with  interest  on  unpaid  installments.  When  the 
payment  is  complete,  the  lease  is  cancelled  and  the  title 
to  the  equipment  passes  to  the  railroad  company. 

In  the  meantime,  in  order  to  pay  the  manufacturers 
the  intermediary  company  issues  bonds  toj-bout^^  90 
per  cent  of  the  cash  value  of  the  equipment.  The  bonds 
are  in  serial  form  so  that  as  fast  as  purchase  money  is 
received  from  the  railroad  it_may  be  devoted  to  Jheir^ 
redemption,  and  the  series  is  so  arranged  that  when  the 
last  payment  by  the  railroad  is  made  the  last  bonds  are 
redeemed. 

The  form  of  an  equipment  trust  bond  is  given  on 
page  137,  and  the  following  extract  from  the  prospec- 
tus of  one  of  the  early  intermediary  companies  in  this 
field  will  further  explain  the  working  of  this  ingenious 
plan,     '^-h^    t:^.^.^- 

The  business  of  the  RailrQad  Equipment  Company  is  to  lease 
and  conditionally  sell  on  what  is  known  as  the  Car  Trust  plan, 
to  railroad  and  other  corporations  directly  connected  therewith, 
certain  needed  Rolling  Stock. 

1^  cash  payment  ranging  from  10  per  cent  to  as  high  even  as 

50  per  cent  is  made  at  the  outset,  and  the  principal  and  interes^t 

of  the  balance  due,  represented  by  the  promissor^^jiotes^£  the 

^  ^Corporation,  maturing  at  fixed  intervals  over  a  term  of  years,  is 

securedHby  a  first  lien  or  mortgage  on  the  s§iid  Rolling  Stocky 


TYPES  OF  CORPORATION  BONDS 


137 


.g  ^  -^  ^  fe  ^3 
<U         C   flj   (U   03 


o 


^  "■•  ^ '-'  a 

O 


to 


^  feij^  a  ^ 


e-a  f^fc  bee's 


138  CORPORATION  FINANCE 

the  whole  of  which  remains  as  such  security  until  the  last  note  is 
paid. 

These  deferred  payments  extend  over  a  period  ranging  from 
four  to  ten  years,  and  during  such  periods  and  until  the  final 
payment  is  made  and  all  the  provisions  of  the  Car  Trust  Con- 
tract have  been  fully  complied  with,  the  conditional  purchaser 
uses  the  Rolling  Stock  as  lessee  only,  and  subject  to  the  legal 
rights  of  the  lessor,  in  whom  the  title  to  the  property  remains 
fixed  and  inalienable  and  unaffected  by  any  liens  or  indebtedness 
of  any  kind  of  the  lessee. 

The  lessee  is  also  bound  by  the  contract  to  keep  the  Rolling 
Stock  in  proper  repair,  to  replace  it  if  destroyed,  and  to  hold  it 
at  all  times  subject  to  the  inspection  (it  being  readily  identified, 
not  only  by  the  road  numbers,  but  by  the  ownership  plates 
invariably  attached  to  each  locomotive  or  car)  of  the  lessor,  by 
whom  and  for  whose  benefit  it  is  fully  insured. 

In  case  of  default  of  any  of  the  payments,  or  of  non-per- 
formance of  the  other  provisions  of  the  contract,  the  lessor  has 
the  legal  right,  not  only  fully  recognized  and  confirmed  by  the 
United  States  Courts,  but  also  protected  by  direct  legislation 
in  many  of  the  States,  to  take  immediate  possession^of  the  Roll- 
ing Stock  wherever  it  may  be,  or  however  in  use,  to  seUJt  at 
public. or  private  sale,  and  to  apply  the  proceeds  to  thejpa,yment 
of  any  indebtedness  jirising  under  the  contract,  whether  matured 
or  not,  and  in  cases  where  a  Receiver  is  appointed,  the  rule  of  the 
Courts  i?  to  order  him  to  pay  the  Car  Trust  notes  as  they  ma- 
ture, rather  than  lose  the  use  of  the  Rolling  Stock  and  the  benefit 
of  the  payment  already  made  on  it. 

The  securitiek^Tarising  under  these  Car  Trusts  are  assigned  to 
a  Trust.^ompany,  and  are  held  by  it  in  trust,  as^ecurity  for 
certain  ^onds  of  The  Railroad  Equipment  Company  issued 
against  the  same. 

The  holder  of  these  Bonds  has  therefore  as  his  security : 

The  direct  obligation  of  the  Railroad  Equipment  Company^ 

The  direct  obligations  maturing  at  specified  dates,  generally 
monthly  or  quarterly,  of  the  Corporation,  the  lessee  of  the  Roll- 
ing Stock. 


TYPES  OF  CORPORATION  BONDS      139 

The  absolute  ownership  of  such  Rolling  Stock  which  is  kept 
in  repair,  insured,  and  replaced  if  destroyed,  and  the  first  cost 
of  which,  already  reduced  by  the  cash  payment  at  the  outset,  is 
being  steadily  still  further  reduced  by  the  periodical  payment 
made  by  the  lessee.*' 

The  security  behind  bonds  of  this  character  is  excel- 
lent. In  the  first  place,  no  railroad  has  ever  yet  de- 
faulted on  an  equipment  trust  bond  issue,  because  to  do 
so  would  mean  a  loss  of  its  equipment.  All  through  the 
railroad  receiverships  of  the  90's  the  receivers  paid  the 
interest  and  principal  on  these  bonds  regularly.  In  the 
second  place,  the  railroad  merely  leases  the  equipment 
until  the  last  payment  is  made  and  in  case  of  default, 
therefore,  no  legal  process  is  necessary  in  order  to  enable 
the  trustee  to  take  physical  possession  of  the  property. 
The  leases  usually  provide  that  the  equipment  is  to  be 
kept  in  good  repair. 

In  effect  this  form  of  security  is  a  kind  of  chattel 
mortgage.  From  the  railroad  corporation  standpoint 
it  is  open  to  the  usual  objection  against  chattel  mort- 
gages, namely,  that  it  pledges  a  semi-fixed  asset  under 
a  short  term  obligation  which  must  be  met  at  all  hazards. 
It  may  well  happen  that  the  railroad,  in  order  to  meet 
this  obligation,  will  have  to  part  with  funds  necessary  in 
order  to  meet  other  fixed  charges.  The  best  managed 
railroad  corporations  use  these  instruments  with  great 
caution.  One  reason  for  their  existence  is  that  many 
existing  first  and  second  mortgages  on  railroad  prop- 
erty have  what  is  called  an  "after-acquired  property" 
clause,  which  makes  the  mortgage  extend  over  aU  the 
property  that  the  railroad  owns  at  the  time  of  making 
the  mortgage  and  all  that  it  acquires  thereafter.  Under 
this  clause  a  straight  mortgage  on  equipment  would  not 


14iO 


CORPORATION  FINANCE 


be  a  first  lien.  The  lease  is  the  method  by  which  this 
difficulty  is  overcome. 

The  market  for  equipment  trust  bonds  is  narrow, 
partly  because  the  public  does  not  thoroughly  under- 
stand them  and  partly  because  the  issues  are  relatively 
small.  They  are  largely  bought  by  banks,  insurance 
companies  and  other  financial  institutions  desiring  to  in- 
vest their  reserve  funds  to  the  best  advantage.  The 
average  yield  on  equipment  trust  bonds  is  considerably 
better  than  on  ordinary  mortgage  bonds  and  their  safety 
is  almost  perfect. 

^  The  principle  of  the  equipment  trust  bonds  is  not 
applied  to  any  considerable  extent  in  industrial  corpo- 
rations and  with  very  few  exceptions  it  would  be  highly 
inadvisable  for  such  corporations  to  buy  equipment  in 
this  manner. 


CHAPTER  XI 

TYPES  OF  CORPORATION  BONDS  (CONTINUED) 

74.  Debenture  bonds. — There  are  two  different  uses 
of  the  word  debenture  which  are  somewhat  confusing. 
In  law  any  instrument  which  formally  acknowledges  a 
debt  and  promises  payment,  including  any  written  bond 
secured  or  unsecured,  is  a  debenture.  In  finance,  how- 
ever, the  term  has  come  to  be  restricted  to  a  bond  which 
isjiot^ecured  by  a  lien  upon  any^  specific  property.  In 
other  words,  it  is  for  all  practical  purposes,  simply  an 
unsecured  promissory  note  running  for  a  number  of 
years.  Being  unsecured,  the  debenture  bond,  in  case 
of  insolvency,  is  on  the  same  level  as  the  general  floating 
indebtedness  of  the  insolvent  corporation. 

The  debenture  is  much  used  in  the  financing  of  Eng- 
lish corporations.  Indeed,  our  American  mortgage 
bond,  in  the  case  of  railroads  at  least,  is  there  almost  un- 
known. It  is  used  so  largely  because  the  English  invest- 
ors realize  clearly  that  the  earnings  of  the  railroad  after 
all  are  their  actual  security.  As  has  already  been  pointed 
out,  the  holders  of  a  railroadmortga^fe-in  case  of  fore^- 
closure  seldom  take  jhe  physical  property  which  legally 
belongs  to  them.  Because  to  separate  any  portion^  of  a 
railroad's  propertyf rom  the  rest  is  to  diminish  and  per- 
haps destroy  its  valueT  Logically,  therefore,  the  Eng- 
lish custom  is  right  and  the  American  custom  is  wrong. 
In  practice,  however,  it  is  probable  that  the  American 
railroad  managers  have  borrowed  more  funds  on  better 
terms  than  have  the  English  railroad  managers.    An 

141 


142  CORPORATION  FINANCE 

English  railroad  corporation  has  only  one  kind  of  a 
bond — ^the  simple  debenture — to  offer;  an  American 
railroad  corporation  may  offer,  as  we  have  seen,  an 
indefinite  variety  of  mortgage  bonds,  each  bond  being 
secured  by  a  lien  on  some  part  or  section  of  the  railroad 
property.  The  American  junior  bond,  for  that  reason, 
looks  better  to  the  average  investor  than  the  English 
junior  bond,  and  is  more  readily  salable.  Notice  that 
this  statement  says  "looks  better,"  not  "is  better."  If 
all  American  railroad  mortgage  bonds  were  to  be  ex- 
changed for  simple  debentures  arranged  in  the  order  of 
their  priority,  investors  would  be  as  well  off  as  they  are 
now. 

Under  the  present  system,  however,  the  existing  de- 
benture bonds  are  for  the  most  part  far  inferior  in  se- 
curity and  investment  standing  to  mortgage  bonds. 
Indeed,  it  would  hardly  be  correct  to  call  any  of  the 
present  railroad  debenture  bonds,  with  a  few  notable 
exceptions,  investments  at  all  in  the  technical  sense  of 
that  word,  as  previously  defined. 

If  debenture  bonds  are  so  far  inferior  to  mortgage 
bonds  and  therefore  so  much  less  attractive  to  investors, 
why  issue  them  at  all?  There  are  several  possible 
reasons.  In  the  first  place,  a  company  may  have  reached 
its  limit,  so  far  as  mortgage  borrowings  are  concerned; 
it  may  have  nothing  of  any  great  value  left  on  which 
first  and  second  mortgages  have  not  already  been  placed. 
Third  mortgages  are  so  unpopular  with  investors  thiat  a 
simple  debenture  may  be  more  easily  sold. 

Sometimes  debenture  bonds  are  created  when  a  bank- 
rupt railroad  company  is  reorganized.  The  reorgan- 
Izers  may  desire  to  lighten  the  load  of  mortgages  that 
previously  weighed  down  the  company  and  perhaps 
caused  its  bankruptcy.     In  the  general  scaling  down  of 


TYPES  OF  CORPORATION  BONDS  148 

the  mortgage  securities — a  subject  which  we  shall  con- 
sider in  detail  when  we  take  up  reorganization — the 
junior  mortgage  issues  are  often  replaced  by  debentures. 
This  is  the  origin  of  most  of  our  present  railroad  de- 
bentures. 

A  tiiird  possible  reason  may  be  that  a  conservative 
corporation  is  anxious  Jo  reserve  some  of  its  resources 
for  future  mortgage  issues.  Suppose  a  railroad,  for 
instance,  already  has  a  first  mortgage  on  all  its  property 
and  desires  to  borrow  a  comparatively  small  additional 
sum.  If  it  places  a  second  mortgage  on  its  property  it 
will  have  used  up  much  of  its  remaining  borrowing 
capacity.  If  it  issues  simple  debentures,  however,  it  will 
still  have  a  second  mortgage  to  fall  back  upon.  Usually 
debenture  bonds  issued  under  such  circumstances  are 
accompanied  by  an  agreement  between  the  corporation 
and  the  bondholders  to  the  effect  that  if  any  new  issue 
of  mortgage  bonds  is  subsequently  put  out  the  debenture 
bondholders  shall  be  secured  by  the  same  mortgage  as 
the  new  bondholders. 

A  fourth  reason  that  has  at  times  led  to  the  issue  of 
debenture  bonds  is  that  they  are  intended  to  be  sold  to 
European  investors,  among  whom,  as  has  already  been 
stated,  such  bonds  are  highly  regarded.  In  the  reor- 
ganization of  the  Wabash  Railroad  Company  in  1887, 
for  instance,  certain  issues  which  are  actually  secured  as 
to  principal  by  a  third  mortgage  were  nevertheless  given 
the  name  of  "debenture  bonds.  Series  A,"  because  they 
were  intended  for  English  investors.  * 

In  this  country  the  most  successful  railroad  debenture 
bond  issues  are  those  of  the  New  England  railroads,  for 
the  obvious  reason  that  the  earnings  of  these  roa(^^re 
not  only  large,  but  particularly  stable.  In  IQoWhe 
Boston  and  Maine  had  outstanding  four  mortgage  bond 


144  CORPORATION  FINANCE 

issues  and  seven  debenture  issues.  All  of  the  de- 
benture bond  issues  commanded  good  prices  and  we»e 
considered  sound  investments.  The  earnings  of  this 
company  averaged  six  or  seven  times  fixed  interest 
charges.  Similarly  in  1909  the  New  York,  New  Haven 
and  Hartford  had  six  issues  of  debenture  bonds  out- 
standing in  addition  to  numerous  issues  of  mortgage 
bonds  of  subsidiary  companies.  The  net  earnings  of 
this  company  were  more  than  three  and  one-half  times 
the  total  interest  charges.  The  practice  of  issuing  de- 
benture bonds  seems  to  be  gradually  gaining  favor 
among  American  railroads,  and  a  number  of  lines  have 
adopted  the  policy  of  replacing  mortgage  issues  when 
they  mature  by  simple  debenture  issues.  The  debenture 
bond  is  not  much  used  by  industrial  corporations,  how- 
ever. These  corporations  do  not  usually  have  the  con- 
fidence of  investors  and  the  stability  of  earning  power 
which  are  necessary  to  make  debenture  bond  issues  suc- 
cessful. 
•*i  75.  Income  bonds^— -The  income  bond  is^Jhybrid, 
partaking  ofThe  nature  of  both  bonds  and  stock.  As 
the  name  implies,  the  payment  of  interest  charges  can 
be  demanded  ^oiily  whenjthere  is  sufficient  income  for 
_that_9urposej_if  the  interest  charges  are  not  earned  they 
need  not  be  paid.  The  principal,  however,  is  usually 
secured  by  a  mortgage.  If  there  is  no  such  mortgage, 
as  happens  in  one  or  two  cases,  the  word  bond  is  a  mis- 
nomer. For  all  practical  purposes  such  an  "income 
bond,"  so-called,  is  preferred  stock  without  voting  power. 
Income  bonds  are^HSuaily  ttie^odiicrofTgnrgamza- 
tion  and  are  designed  to  take  the  place  of  junior  mort- 
gJ^  bond  issues  which  it  is  thought  necessary  to  scale. 
Their  advantage  lies  in  the  fact  that  they  do  not  impose 
any  fixed  interest  charges  on  the  corporation.     How- 


TYPES  OF  CORPORATION  BONDS  145 

ever,  there  is  a  great  disadvantage  in  the  fact  that  the 
principal  is  secured  by  mortgage  and  that  therefore  new 
mortgage  bond  issues  in  the  future  are  hard  to  float. 
Another  disadvantage  is  that  there  is  apt  to  be  dispute 
between  the  corporation  and  the  bondholders  as  to 
whether  the  interest  charges  are  actually  earned  or  not. 
This  objection  can  be  obviated  in  part  by  inserting  in  the 
bond  such  a  detailed  statement  of  the  method  by  which 
net  income  is  to  be  determined  as  is  given  in  the  sample 
income  bond  shown  on  pages  146  and  147.  The  new 
system  of  railroad  accounting  under  the  Interstate  Com- 
merce Commission  will  probably  aid  in  the  settlement  of 
this  question  in  connection  with  railroad  companies. 
For  an  example  of  the  difficulties  inherent  in  income 
bonds  see  the  case  of  the  Central  of  Georgia  Railway 
Company  cited  in  Chapter  XXVI. 
<»  76.  Other  types  of  bonds, — The  name  of  ^'participat- 

jngjbonds,."  is  almost  self-explanatory.  A  bond  of  this 
class  usually  gets  a  fixed  rate  of  interest  and  in  addition 
a  share  of  whatever  profits  are  earned  by  its  underlying 

^ecurity.     The  best  known  issue  of  this  kind  was  the 

Oregon  Short  Line  participating  4's  issued  in  1903  and 

retired  the  next  year,  which  were  secured  by  all  the  stock 

of  the  Northern  Securities  Company,  amounting  to  $82,- 

491,000  in  the  Oregon   Short  Line  treasury.     These 

bonds  were  to  receive  not  only  the  regular  4  per  cent. 

but  whatever  dividends  over  4  per  cent   were  declared 

on  the  collateral  stock. 

JProfit::sharm^_bOT  are  infrequently  issued, 

usually  entitle  the  bondholder  to  get  back  his  principal 

with  the  agreed  interest  and  also  to  share  in  whatever 

increase  in  thejvalue  ^fjthe  underlying  assets  may  take 

^lace-  before  the  retirement  of  the  bonds. 

Joint  bonds  are  direct  obligations  of  twOipr  more  cor- 
I— Id  --ri^:- 


14!6 


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TYPES  OF  CORPORATION  BONDS  147 

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TYPES  OF  CORPORATION  BONDS      149 

porations  which  join  in  issuing  them.  A  well-known 
example  is  the  Northern  Pacific-Great  Northern  issue  of 
joint  collateral  trust  4's.  Somewhat  the  same  effect  is 
gained  when  a  holding  company  guarantees  a  subsidiary- 
company  bond  issue. 

A  corporate  security  which  should  be  mentioned  here, 
although  it  is  not,  strictly  speaking,  a  bond,  is  a  receivers' 
certificate.  .  This  represents  mon^y^^xpended^by  the  re^ 
ceiver&  jo£^an  4nsQlY£nt  corporation  under  authority  of 
the  court,  as  shown  in  the  sample  given  on  page  148. 
They  constitute  a  claim  on  jhe^operty  of  the^orpora-^ 
tionjsuperiorjto  all  other  claims  whatsoever.  They  go 
ahead  of  the  first  mortgage  bonds.  They  do  not,  of 
course,  usually  exist  in  large  quantities  and  a  reorgan- 
ized corporation  will  endeavor  to  refund  and  pay  them 
off  as  quickly  as  possible.  It  is  well  to  bear  in  mind, 
however,  that  in  the  case  of  an  insolvent  corporation  this 
kind  of  a  security  may  be  used  as  a  Jast  resprtj^hen 
funds  could  hardly  be  secured  in  any  other  manner. 

77.  Purposes^  manner  of  payment,  and  conditions  of 
redemption  of  bonds. — The  descriptive  words  applied 
to  bonds  indicating  their  purposes  are  almost  all  self-ex- 
planatory. "Unifying,"  "refunding,"  "adjustment" 
and  "consolidated"  imply  that  the  previous  bond  issues 
are  to  be  retired  or  rearranged  in  some  way.  "Con- 
struction," "improvement"  and  "extension"  show  that 
the  funds  secured  from  the  bond  issue  are  to  be  expended 
in  some  kind  of  development.  "Purchase-money"  bonds 
are  sold  before  the  property  on  which  they  are  based  is 
actually  bought.  Usually  the  funds  secured  by  the  sale 
of  the  bonds  are  turned  over  to  a  trustee  to  be  held  until 
certain  specific  property  is  purchased.  Then  the  funds 
are  paid  out  by  the  trustee  and  he  receives  in  return  a 
first  mortgage  on  the  property. 


150  CORPORATION  FINANCE 

A  registered  bond  is  issued  to  an  individual  in  the 
same  manner  as  a  certificate  of  stock  and  ownership  can 
be  transferred  only  on  the  books  of  the  company.  In- 
terest is  paid  by  checks  which  are  sent  out  to  the  reg- 
istered owner.  Coupon  bonds  are  usually  payable  to 
bearer  and  interest  payments  are  represented  by  coupons 
attached  to  the  bond,  as  indicated  in  the  bond  forms  given 
on  pages  123  and  137.  When  the  interest  date  ap- 
proaches, the  coupon  is  detached  from  the  bond  and  de- 
posited in  a  bank  just  as  a  check  on  the  corporation 
would  be  deposited.  In  fact,  the  coupons  are  practi- 
cally simply  post-dated  checks.  Sometimes  coupon 
bonds  are  registered  as  to  principal,  in  which  case  trans- 
fer of  ownership  is  not  made  simply  by  dehvery,  but 
must  pass  through  the  books  of  the  company.  The  in- 
terest coupons,  however,  are  payable  to  bearer.  Fre- 
quently an  issue  of  bonds  may  be  either  coupon  or  reg- 
istered at  the  option  of  the  buyers. 

There  are  obvious  advantages  in  each  form.  The 
coupon  form  is  very  convenient,  inasmuch  as  it  may 
readily  be  sold  or  hypothecated.  The  registered  form 
makes  up  in  safety  what  it  lacks  in  convenience.  If 
it  is  lost  or  stolen  it  can  be  negotiated  only  by  a  forgery 
of  the  signature  of  the  person  in  whose  name  it  stands, 
in  which  case  the  transfer  would  not  be  valid.  When  a. 
coupon  bond  is  lost  or  stolen  and  is  once  sold  to  an  in- 
nocent purchaser  for  value,  the  original  owner  must 
stand  the  loss. 

A  gold  bond  is  one  which  specifies  that  payment  of 
principal  and  interest  shall  be  made  in  gold  coin.  If 
there  is  no  such  provision  it  is  understood  that  legal 
tender  will  be  acceptable.  There  have  been  times  in 
the  history  of  the  United  States,  notably  during  the 
periods  of  greenback  inflation  and  of  free  silver  agita- 


I 


TYPES  OF  CORPORATION  BONDS      161 

tion,  when  this  gold  coin  provision  was  regarded  as 
highly  important.  At  present  not  a  great  deal  of  at- 
tention is  given  to  it. 

Redeemable  bonds  are  those  which  may  be  redeemed 
at  the  option  of  the  corporation  before  date  of  maturity. 
Sometimes  the  selection  of  the  particular  bonds  to  be 
redeemed  is  made  by  lot  and  the  terms  of  redemption 
are  made  attractive  with  a  view  to  appealing  to  investors 
with  a  speculative  twist  of  mind.  The  wisdom  of  issuing 
redeemable  bonds  is  questionable.  It  introduces  an  ele- 
ment of  chance  which  makes  it  very  difficult  to  figure 
mathematically  their  exact  value  and  which  probably 
tends  to  depress  their  market  price. 

Serial  bonds  are  redeemable  in  series  extending  over  a 
term  of  years. 

^  78.  Convertible  bonds, — This  is  a  type  of  security  that 
was  revived  a  number  of  years  ago,  and  has  since  be- 
come increasingly  popular.  It  may^be  changed  or  con- 
verted  under  certain  conditions  into  some  other  kind  of 
security — ugually  into'  stock.  The  privilege  of  con- 
version may  belong  to  any  kind  of  a  bond,  mortgage, 
debenture,  collateral  trust  or  income.  The  usual  ar- 
rangement is  to  permit  a  mortgage  bond  to  be  ex- 
changed for  preferred  stock  of  the  issuing  corporation 
at  a  prescribed  rate  of  exchange  and  within  a  certain 
definite  period. 

For  instance,  the  Union  Pacific  Railroad  issued  in 
1901,  $100,000,000,  of  4  per  cent  bonds  which  were  con- 
vertible into  common  stock  at  par.  As  Union  Pacific 
common  sold  in  1907  and  1908,  at  an  average  price  much 
higher  than  par,  practically  all  of  this  issue  was  con- 
verted long  before  the  expiration  of  the  time  limit  set. 

The  advantage  of  this  scheme  is  thatit^give_s  bonds  a^ 
sgeculative,  in  addition  to  their  investmenVvalue.     The 


153  CORPORATION  FINANCE 

buyer  figures  that  he  gets  as  safe  an  investment  security 
as  he  would  have  if  there  were  no  such  privilege  and  in 
addition  he  may  share,  if  he  chooses,  in  any  great  upward 
movement  of  the  stock.  The  privilege  of  convertibility 
enables  the  company  to  borrow  at  a  iowex_rate__iiLin^ 
Jterest.  A  further  advantage,  from  the  corporation's 
standpoint,  is  that  the  company  if  successful  may  expect 
to  be  relieved  by  the  process  of  conversion  of  the  pay- 
ment of  interest  on  the  bonds.  Thus  room  will  be  made 
for  additional  future  issues  of  bonds,  if  such  issues  are 
regarded  as  necessary. 

From  the  investor's  point  of  view  the  advantages  of 
convertible  bonds  are  summed  up  in  a  circular  by  Mr. 
Henry  Hall  issued  in  March,  1909.  Notice  that  this 
circular  recommends  the  bonds  to  the  semi-investing 
rather  than  to  the  strictly  investing  public. 

Convertible  bonds  belong  to  the  sounder  class  of  speculative 
investments,  combining  a  reasonable  degree  of  safety  and  cer- 
tainty of  interest  return,  with  possibilities  of  substantial  en- 
hancement in  value.  Investors  make  from  25  to  50  per  cent 
profit,  sometimes  more,  on  convertible  bonds  when  properly 
bought. 

Convertible  bonds  were  first  issued  in  this  country  forty  and 
fifty  years  ago,  when  the  financing  of  even  the  most  promising 
of  American  railroads  and  at  a  high  rate  of  interest  was  a  diffi- 
cult matter,  and  when  it  was  occasionally  necessary  to  offer 
special  inducements  to  ensure  the  success  of  a  new  loan.  Most 
of  the  financing  of  St.  Paul,  for  instance,  for  twenty  years 
or  more  after  1860,  was  accomplished  through  the  issue  of  this 
class  of  bonds.  It  is  said  that  as  late  as  1896,  there  were  yet 
outstanding  twelve  separate  convertible  issues  of  the  St.  Paul. 
From  1880  to  1900,  few  or  no  issues  of  convertibles  were  made; 
but  the  requirements  of  the  railroads  then  became  so  imperative 
and  the  multiplicity  of  competing  issues  became  so  great,  that  in 
1900  and  1901  the  convertible  idea  was  once  more  resorted  to. 


TYPES  OF  CORPORATION  BONDS      153 

In  a  general  way,  convertible  bonds  tend  always  to  follow 
the  price  of  the  stock  for  which  they  are  exchanged.  This  tend- 
ency is  clearly  exhibited  by  the  quotations  in  this  circular. 
Their  fluctuations  in  price  are  therefore  more  lively  than  those 
of  staid  first  mortgage  and  other  strong  issues.  An  ordinary 
bond  of  good  standing  seldom  moves  more  than  5  to  10  points 
from  year  to  year,  while  convertibles  are  apt  to  fluctuate  from 
10  to  30  points  in  a  single  twelve  months.  The  Erie  4s,  Series 
A,  fell  from  109%  in  one  year  to  46%  in  the  next  and  then  rose 
to  8OI/2. 

Convertible  bonds  are  always  a  direct  obligation  of  the  com- 
pany. Some  of  these  issues  are  secured  by  mortgage.  Others 
are  not,  but  this  latter  fact  does  not  necessarily  impair  their 
value.  It  merely  suggests  a  careful  scrutiny  of  general  condi- 
tions and  the  business  of  the  company  before  buying  them. 

Of  course  there  are  corresponding  disadvantages. 
The  stockholder  may  well  say  that  if  the  company  is 
going  to  be  successful  it  would  be  far  better  to  let  the 
bonds  stand  and  thus  save  more  of  the  income  for  the 
stockholders.  On  the  other  hand,  if  the  company  is  not 
successful,  the  bonds  will  not  be  converted  into  stock. 
The  stockholder  sees  loss  for  himself  in  either  alterna- 
tive. This  would  perhaps  be  an  unanswerable  argu- 
ment, if  it  were  not  for  the  fact  that  the  bonds  are  almost 
always  offered  at  less  than  market  prices  to  stockholders, 
so  that  the  holders  of  convertible  bonds  and  the  holders 
of  stock  are  likely  to  be  the  same  persons ;  or  at  least  the 
stockholder  gets  a  valuable  privilege  in  the  form  of  a 
right  to  subscribe  to  the  bond  issues. 


CHAPTER  XII 

CORPORATE  PROMOTION— THE  NEW  ENTERPRISE 

79.  The  function  of  a  promoter, — ^A  promoter  is  a 
manjHfho  organizes  a  new  business  and  sets  it  going. 
The  business  need  not  necessdli-ily  take  the  form  oF  a 
corporation.  It  may  be  handled  as  a  partnership  or  a 
joint  stock  company.  As  new  enterprises  at  the  present 
time,  if  of  any  magnitude,  are  ahnost  always  conducted 
by  corporations,  however,  it  will  be  convenient  and  not 
far  f I'om  the  truth  to  speak  as  if  the  work  of  a  promoter 
were  confined  to  organizing  and  financing  corporations. 

The  promoter  is  necessary  because  the  great  mass  of 
the  funds  used  in  large  corporate  enterprises  is  passive ; 
that  is  to  say,  the  owners  of  investment  funds  are  not 
primarily  engaged  in  buying  and  handling  business  en- 
terprises. They  wait  until  a  good  proposition  is  pre- 
sented to  them.  The  function  of  the  promoter,  there- 
fore, is  to  bring  his  proposition  to  tEe  atFention  of  the 
owners  of  funds  in  such  a  manner  as  to^  arouse^heir  in- 
terest and  confidence  aQd  induce  tibiem  to  buy  the 
securities  of  his  new  corporation. 

The  word  promotion  has  a  tinge  ofdiscredit  attached 
to  it,  partly  because  the  promoter,  from  the  very  nature 
of  his  work,  is  apt  to  be  over-sanguine  and  a  little  care- 
less as  to  exact  accuracy,  and  partly  because  the  high- 
sounding  word  promotion  is  used  by  many  swindlers 
who  prey  upon  ignorant  and  foolish  speculators. 

One  of  these  last  mentioned  gentry  describes  his 
operations  in  the  following  words: 

154 


CORPORATE  PROMOTION  155 

To-day  the  promoter — the  20th  Century  genii — takes 
an  existent  business  enterprise,  and,  for  every  five  dollars  it 
annually  earns,  gives  it  immediately  ninety-five  dollars.  He 
takes  an  Opportunity — an  intangible,  impalpable  thing — and 
from  it  creates  an  actuality,  a  vigorous  growing  enterprise  that 
showers  wealth  and  happiness  on  thousands.  He  takes  appar- 
ently irreconcilable  interests,  waves  his  promotion  wand  above 
them,  and  presto !  they  become  associated  by  the  bands  of  com- 
mon interest ;  loyal  to  a  single  standard.  Over  business  men  he 
throws  a  mantle  that  protects  their  private  means  against  bank- 
ruptcy, litigation  or  ruin.  He  carries  a  veritable  Aladdin's 
Lamp — the  Lamp  of  Knowledge,  the  Lamp  of  Power,  through 
which  he  conjures  opportunities  into  actualities,  small  businesses 
into  large.  His  powers,  legitimately  employed,  upbuild  indus- 
try. Literally,  in  service  to  humanity,  he  stands  with  powers  as 
beneficent  as  those  exhibited  by  the  Good  Genii  of  our  child- 
hood tales. 

The  end  of  this  quotation,  when  applied  to  men  whose 
sole  object  is  to  draw  into  their  own  pockets  as  much  as 
they  can  of  the  savings  of  their  credulous  victims,  is 
sufficiently  absurd.  But  when  it  is  restricted  to  the  true 
promoter,  a  man  whose  judgment  and  business  instincts 
are  sound  and  whose  persuasive  powers  are  used  to  se- 
cure funds  for  a  legitimate  business  enterprise,  the  state- 
ments are  not  at  all  exaggerated.  The  promoter  does, 
in  fact,  perform  highly  important  tasks  and  often  richly 
deserves  the  great  rewards  which  fall  to  his  share. 
Many  of  the  great  business  men  of  America  are  pro- 
moters— though,  as  noted  in  the  next  chapter,  such  men 
do  not  usually  spend  all,  or  even  most,  of  their  energies 
in  promotion  work.  To  this  class  belong  H.  H.  Rogers, 
John  W.  Gates,  D.  G.  Reid,  Judge  W.  H.  Moore,  and 
many  others.  Closely  allied  with  them  are  other  men, 
primarily  financiers,  but  concerned  more  or  less  with 


156  CORPORATION  FINANCE 

promotion,  such  as  J.  P.  Morgan,  E.  H.  Harriman, 
George  F.  Baker  and  James  Stillman. 

80.  ''Discovery"  of  a  proposition, — A  promoter  in 
handling  an  enterprise  has  three^epaxatg,  tasks^ef ore 
him.  First,  he  must  "discover."  his  proposition;  second, 
he  must  "assemble,"  it;  third,  he  must  "finance"  it. 

The  discovery  of  a  proposition  does  not  mean  simply 
to  find  it,  but  includes  a  thorough  investigation  into  all 
the  surrounding  conditions,  and  the  solution  in  advance 
of  all  the  difficult  problems  that  are  likely  to  arise  in  its 
development.  Let  us  suppose,  for  instance,  that  a  new 
invention  which  looks  good  on  the  surface  is  brought  to 
the  attention  of  a  promoter.  If  he  understands  his 
business  he  will  first  of  all  examine  critically  every  point 
that  points  toward  the  invention's  success  or  failure. 
He  will  find  out  whether  it  is  patented  and  just  what 
features  the  patent  covers.  If  it  is  not  patented,  he  will 
make  sure,  through  a  competent  patent  attorney,  that 
the  device  is  actually  new  and  patentable.  If  he  is 
prudent  he  will  probably  instruct  the  attorney  to  find 
out  whether  any  similar  invention  is  used  in  foreign 
countries  or  not.  Next,  he  will  consider  whether  other 
devices  are  in  use  which  perhaps  accomplish  the  same 
purpose  as  well  or  nearly  as  well  as  the  invention.  After 
making  sure  that  the  invention  is  what  it  purports  to  be, 
he  will  consider  the  possible  markets  for  the  article. 
The  invention  may  be  a  new  machine  that  could  be  used 
in  only  a  few  concerns,  and  perhaps  these  concerns 
would  prefer  to  retain  their  present  machines  rather 
than  expend  any  great  amount  of  money  for  something 
new.  In  this  connection  the  promoter  will  have  to  find 
out  whether  any  incidental  expenses  are  necessary  in 
connection  with  the  use  of  the  invention.  Generally 
speaking,  the  slighter  the  change  from  current  methods. 


CORPORATE  PROMOTION  157 

the  more  readily  the  invention  may  be  marketed.  The 
amount  of  advertising  and  selling  expense  called  for 
must  also  be  taken  into  account. 

Next,  the  promoter  takes  up  the  cost  of  manufactur- 
ing. He  finds  out  whether  new  and  specially  con- 
structed machinery  is  necessary  in  manufacturing  the 
invention,  and  whether  any  especial  skill  on  the  part  of 
laborers  is  required.  He  considers  the  amount  of  ex- 
periment that  will  be  necessary  in  order  to  perfect  the 
invention  and  in  addition  figures  a  large  amount  of  ex- 
tra cost  for  unforeseen  contingencies. 

These  are  only  a  few  of  the  factors  that  the  promoter 
would  investigate  before  taking  any  further  action. 
Their  number  is  sufficient  to  indicate,  however,  that  any 
promoter  who  has  a  reputation  to  make  or  preserve,  can- 
not aff*ord  to  jump  hastily  at  whatever  proposition  is 
presented  to  him.  The  process  of  discovery  may  take  a 
long  time,  perhaps  months  or  even  years. 

The  case  just  cited  is  comparatively  simple.  Where 
a  promoter  is  dealing  with  such  an  enterprise  as  a  new 
railroad  or  a  new  mine  or  with  a  consolidation  of  manu- 
facturing plants,  he  is  confronted  by  a  far  more  com- 
plicated situation.  If  the  investigation  is  thorough  and 
searching,  the  promoter  will  be  able  to  give  a  well- 
grounded  and  satisfactory  answer  to  every  question  that 
prospective  buyers  may  raise. 

81.  ^' Assembling'^  a  proposition. — By  assembling  a 
proposition  is  meant  the  process  of  getting  temporary 
control  into  the  hands  of  the  promoter.  If  he  is  dealing 
with  an  invention,  he  assembles  the  proposition  by  get- 
ting an  option  on  the  invention  or  by  making  an  agree- 
ment with  the  inventor  on  a  royalty  basis.  In  the  case 
of  a  consolidation  of  plants  or  railroads  into  a  new  cor- 
poration, assembling  is  frequently  much  more  compli- 


158  CORPORATION  FINANCE 

cated  and  difficult.  In  such  a  case  the  promoter  may 
have  to  get  options  or  arrange  the  terms  of  purchase 
with  every  plant  and  perhaps  with  all  the  different 
classes  of  security-holders  involved.  Unless  a  promoter 
has  these  agreements  or  options  in  his  own  hands,  it  is  as 
a  rule  foolish  for  him  to  go  ahead  with  any  further 
efforts.  He  might  complete  his  arrangements  for  put- 
ting the  new  corporation  on  its  feet  and  then  find  that 
in  the  meantime  the  original  owners  of  the  property  had 
sold  to  other  parties  or  had  taken  steps  that  would  di- 
minish the  value  of  the  property.  Or  he  might  find  that 
after  forming  the  corporation  and  bringing  the  owners 
of  the  funds  and  the  owners  of  the  property  together, 
they  would  mutually  agree  to  dispense  with  his  services 
and  would  leave  him,  so  far  as  his  compensation  is  con- 
cerned, out  in  the  cold. 

82,  Financing  a  proposition — The  initial  develop- 
ment— Now  we  come  to  the  most  difficult  part  of  the 
promoter's  work,  his  financing  of  the  new  corporation. 
No  hard  and  fast  rules  can  be  laid  down  to  cover  the 
promoter's  procedure.  There  are  some  general  prin- 
ciples, however,  which  apply  to  all  enterprises  and  which 
should  always  be  kept  in  mind. 

First,  it  is  advisable  in  practically  every  case  to  de- 
velop the  proposition  as  far  as  possible  with  the  pro- 
moter's own  resources  and  those  of  his  immediate  friends 
before  it  is  presented  to  outsiders.  In  making  this 
statement  it  is  assumed,  of  course,  that  the  promoter 
really  has  faith  in  his  proposition  and  is  willing  to  take 
whatever  risk  is  involved  in  developing  it;  otherwise  the 
promoter  will  naturally  spend  as  little  as  possible  of  his 
own  money.  In  the  case  of  an  invention,  for  instance, 
which  the  promoter  is  trying  to  finance,  it  is  far  better 
to  have  the  invention  actually  manufactured  and  a  few 


CORPORATE  PROMOTION  159 

of  the  articles  on  exhibition  before  any  attempt  is  made 
to  interest  outside  capital.  If  this  is  impossible,  a  work- 
ing model  at  least  should  be  on  hand.  The  average  capi- 
tahst  is  not  likely  to  part  with  his  money  unless  he  sees 
before  him  something  more  tangible  and  impressive  than 
a  verbal  description  of  what  the  inventor  expects  his 
as  yet  unborn  machine  to  accomplish. 

If  a  promoter  is  financing,  let  us  say,  a  copper  mine, 
he  should  do  his  utmost  to  have  the  ore  bodies  opened 
up  and  mining  operations  started,  even  if  only  on  a  small 
scale,  before  he  starts  to  float  his  corporation.  Where 
the  promoter  is  consolidating  several  existing  plants  he 
already  has  some  of  his  exhibits  at  hand  in  the  form  of 
the  going  plants  and  companies  that  are  to  be  consoli- 
dated. Nevertheless,  the  combination  itself  is  in  re- 
ality a  new  enterprise  and  the  promoter  should  spare  no 
pains  to  secure  some  practical  demonstration  of  its  prof- 
it-making possibilities.  Sometimes  he  may  point  to  the 
success  of  previous  combinations  created  under  closely 
similar  conditions.  If  he  does  not  have  examples,  at 
least  he  can  get  exact  figures  as  to  the  selling,  admin- 
istrative and  operating  expenses  under  the  present  ar- 
rangement which  would  be  saved  if  the  combination  were 
effected. 

In  general  the  promoter  must  bear  in  mind  that  an 
enterprise  which  exists  only  on  paper  does  not  make 
anything  like  as  powerful  an  appeal  to  the  buyer  of 
securities  as  an  enterprise  which  has  something  tangible 
to  show.  It  may  be  that  the  standing  and  prospects  of 
the  enterprise  are  in  reality  very  Httle  changed  simply 
by  producing  some  tangible  results.  Nevertheless,  the 
confidence  of  people  with  funds  is  much  increased  and 
this,  after  all,  is  the  promoter's  main  object. 


160  CORPORATION  FINANCE 

83.  Foresight  in  providing  funds, — Second,  the  pro- 
moter should  take  care  not  to  get  his  enterprise  into 
such  a  condition  that  funds  must  be  secured  immedi- 
ately on  whatever  terms  are  demanded.  This  is  a  situ- 
ation that  is  quite  apt  to  confront  one  who  goes  ahead 
with  construction  and  development  too  rapidly.  In  his 
eagerness  to  make  a  favorable  showing  he  may  perhaps 
run  short  of  funds,  find  the  obligations  of  his  corpora- 
tion pressing  and  be  compelled  to  make  some  very  dis- 
advantageous deals  or  see  his  corporation  go  into  bank- 
ruptcy. Many  a  meritorious  enterprise  has  suffered 
this  fate. 

To  prevent  such  a  catastrophe  the  promoter  should 
see  that  his  corporation  is  capitalized  for  a  larger  amount 
than  he  expects  to  need ;  thus  there  will  always  be  unused 
securities  which  may  be  offered  for  sale  without  involv- 
ing tedious  and  unnecessary  formalities.  It  may  be 
well  to  have  this  stock  actually  issued  and  transferred 
to  the  treasurer  of  the  company  in  the  manner  which 
has  been  previously  described. 

Furthermore,  the  promoter  should  endeavor  to  raise 
in  advance  of  any  expensive  construction  or  develop- 
ment all  the  funds  that  will  be  required  for  that  purpose. 
The  corporation  which  has  a  factory  half -built,  or  min- 
ing machinery  partially  installed,  or  mercliandise  busi- 
ness half -stocked,  is  in  an  extremely  precarious  condi- 
tion. Without  additional  funds  it  can  go  neither 
backward  nor  forward.  It  has  no  valuable  assets  or 
established  trade  on  which  to  borrow  funds,  it  has  no 
trade  credit,  it  has  no  record  of  sales  and  profits  to  pre- 
sent to  prospective  buyers  or  securities.  It  is  therefore 
unable  to  secure  any  funds  except  from  some  individual 
or  small  group  who  may  come  to  its  rescue.  The  pro- 
moter may  feel  reasonably  confident  that  their  assistance 


CORPORATE  PROMOTION  161 

will  be  purchased  only  with  the  sacrifice  of  his  own 
control  and  probably  of  most  of  his  profits. 

84.  Advantages  of  a  wide  distribution  of  stock. — 
Third,  it  is  usually  far  better  both  for  himself  and  for 
the  corporation  that  the  promoter  sell  his  securities  to  a 
large  number  of  small  buyers  rather  than  to  a  small 
number  of  large  buyers.  In  the  former  case  the  stock- 
holders are  scattered  and  their  holdings  are  too  small  to 
induce  them  to  take  any  active  interest  in  the  business. 
Consequently  the  promoter,  even  if  he  fails  to  retain  a 
majority  of  the  voting  stock,  is  left  in  absolute  control. 
In  the  second  case,  the  promoter  is  watched  and  perhaps 
hampered  by  the  large  stockholders;  even  if  he  holds  a 
majority  of  the  voting  stock,  he  will  probably  not  desire 
to  arouse  their  objections  and  will  therefore  feel 
obliged  to  consult  them  or  their  representatives.  Such 
an  arrangement  the  promoter  who  has  faith  in  his 
own  abilities  and  ideas  does  not  desire.  He  usually 
feels  that  he  understands  the  proposition  better  than 
anyone  else  and  that  to  him  should  be  left  the  con- 
duct of  the  business  until  it  is  well  started  toward 
success. 

From  the  standpoint  of  the  corporation,  a  large 
number  of  small  stockholders  is  almost  always  desirable. 
The  wider  the  distribution  of  the  stock,  the  more  friends 
the  corporation  has  and  the  easier,  probably,  will  be  the 
selling  of  additional  securities.  Besides,  the  large 
capitalists  who  might  be  interested  in  the  enterprise, 
should  generally  be  kept  in  reserve  for  such  emergencies 
as  have  been  described.  If  the  corporation  does  get  into 
difficulties,  in  spite  of  all  the  care  that  its  promoter  may 
take,  it  can  then  turn  as  a  last  resort  to  these  capitalists 
instead  of  drifting  helplessly  into  insolvency. 

85.  ''Starting  right"  in  the  sale  of  stock, — Fourth,  if 
I— 11 


16^  CORPORATION  FINANCE 

the  promoter  is  handling  a  legitimate  small  enterprise, 
he  should  look  for  his  funds  to  the  people  of  the  locality 
where  the  enterprise  is  started.  If  the  enterprise  is  too 
large  for  them,  at  least  he  should  accomplish  his  pre- 
liminary financing — that  is,  the  raising  of  sufficient 
funds  to  get  the  enterprise  started,  although  not  enough 
to  carry  it  on  to  success — among  the  local  people.  Con- 
servative bankers  and  business  men  always  recognize  the 
superior  opportunities  for  getting  exact  information  of 
local  investors  and  have  considerable  confidence  in  their 
judgment.  It  is  a  great  advantage  to  a  promoter  in 
presenting  his  enterprise  to  the  public  to  be  able  to  say 
that  a  large  part  of  the  funds  have  been  subscribed  by 
persons  who  are  on  the  ground  and  in  close  touch  with 
what  is  actually  being  accomplished.  The  same  ob- 
servations apply  to  people  with  technical  training  if  the 
enterprise  has  many  difficult  technical  features.  The 
promoter  of  a  corporation  to  manufacture  a  new  elec- 
trical engine,  for  instance,  ought  to  have  the  support 
of  experts  in  that  field — ^manifested  not  only  in  words, 
but  by  money — before  he  starts  his  campaign  for  sub- 
scriptions among  outsiders. 

86.  A  concrete  illustration. — The  practical  applica- 
tion of  the  principles  here  laid  down  in  the  promotion 
and  financing  of  interurban  electric  railroads  has  been 
well  described  in  a  lecture  before  the  students  of  New 
York  University  School  of  Commerce,  Accounts  and 
Finance  by  Dr.  Thomas  Conway,  Jr.,  of  the  University 
of  Pennsylvania.     Dr.  Conway  said:  fl 

The  proposition  having  been  discovered  and  thoroughly  in- 
vestigated, and  the  necessary  options,  for  example  the  rights  of 
way,  etc.,  together  with  the  necessary  franchises,  having  been 
obtained,  the  promoter  arranges  to  present  the  proposition 
to  those  who  will  furnish  the  money  necessary.     He  accora- 


CORPORATE  PROMOTION  163 

panics  his  statement  of  anticipated  earnings,  with  a  map  of  the 
territory,  showing  population  adjacent  and  tributary  to  his 
proposed  lines,  and  he  submits  also  engineers'  estimates  of  cost 
of  construction  and  cost  of  operation,  based  on  the  amount  of 
traffic  to  be  expected  from  the  given  population  and  its  ratio  of 
increase,  and  the  grades  and  curves  which  will  be  encountered. 
He  is  now  ready  to  arrange  for  the  financing  of  his  proposition. 
His  first  step  is  to  organize  a  corporation,  usually  under  the 
laws  of  a  state  in  which  his  road  expects  to  operate.  This  cor- 
poration will  be  organized  with  a  minimum  capital  permitted  by 
laws  of  the  state  in  order  to  save  initial  taxes  payable  to  the 
state.  It  will  be  organized  with  a  minimum  amount  of  cash 
payment  and  if  possible,  requirements  for  actual  contributions 
will  be  satisfied  by  turning  in  options  to  the  company.  The 
charter  of  the  company  contains  the  authorization  of  the  amount 
of  capital  which  will  be  required  to  finance  the  enterprise.  This 
capital  consists  of  bonds,  preferred  and  common  stock.  It 
is  important  that  the  amount  of  bonds  per  mile  of  road  should 
be  kept  down  to  the  lowest  practicable  figure  as  a  large  bonded 
debt  immediately  arouses  a  suspicion  and  suggests  the  advisa- 
bility of  a  more  skeptical  and  scrutinizing  investigation  of  the 
promoter's  representations.  The  amount  usually  fixed  upon  as 
conservative  is  $20,000  per  mile.  This  may  be  exceeded  in 
cases  of  especially  expensive  construction  where  interest  on  an 
excessive  amount  may  be  offset  by  lower  cost  of  maintenance. 

The  preferred  stock  issue  is  usually  for  subscription  in  the 
immediate  locality  where  interest  in  the  new  proposition  must  be 
aroused.  It  is  advantageous  to  secure  the  largest  possible 
amount  in  this  manner,  since  it  gets  down  the  amount  of  bonds 
to  be  sold  and  makes  their  sale  correspondingly  easy.  Two 
courses  of  action  are  now  open  to  the  promoter.  He  may  either, 
after  securing  the  proper  introductions,  address  himself  to  a 
private  banker  in  some  financial  center  and  offer  to  him  the  en- 
tire bond  issue,  or  he  may  arrange  for  the  financing  of  his  enter- 
prise in  his  own  locality,  approaching  the  city  banker  only  after 
he  has  a  record  of  earnings  upon  which  to  base  his  argument. 

The  investor  to  whom  these  securities  must  be  sold,  will  not 


164  CORPORATION  FINANCE 

buy  the  bonds  of  an  enterprise  which  has  no  recognized  status, 
so  long  as  it  remains  in  formation  and  in  chaotic  condition. 
It  is  in  his  eyes  a  speculation  and  as  such  he  is  reluctant  to  put 
his  money  into  its  securities.  If  the  bonds  are,  therefore,  sold 
in  the  city,  to  the  city  banker,  he  must  borrow  the  money  to 
build  the  road,  and  must  hold  the  bonds  until  at  least  a  year's 
operation  of  the  new  property  has  been  completed.  The  city 
banker  will  demand  hard  terms  as  a  condition  of  advancing  this 
money,  if  indeed  one  can  be  found  with  sufficient  confidence  in 
the  new  enterprise  to  risk  his  capital  in  its  inauguration. 

It  is  better,  therefore,  if  possible,  that  the  promoter  should 
arrange  for  a  preliminary  financing  of  his  scheme  among  local 
interests.  This  he  does  in  the  first  place  by  securing  subscrip- 
tions to  preferred  stock  as  already  indicated.  He  also  obtains 
a  guarantee  of  purchase  of  the  bonds  of  his  corporation  from 
local  interests,  bankers,  institutions  and  capitalists,  with  whom 
he  is  acquainted,  the  condition  of  the  guarantee  being,  that  if 
the  bonds  are  not  sold  within  a  definite  time,  say  three  years, 
above  the  price  named  In  the  contract  of  guarantee,  the  guar- 
antors will  take  them  at  that  price.  The  city  banker  would  usu- 
ally require  that  local  interests  guarantee  at  least  a  portion  of 
the  bonds,  and  it  is  therefore  just  as  well  for  a  promoter  if  he 
can  accomplish  this  to  secure  guarantee  of  the  entire  issue,  in 
order  to  make  the  stock  of  his  company  fully  paid  a  device  fre- 
quently resorted  to  is  that  of  a  construction  company  organized 
by  the  promoter  and  his  friends  and  associates,  who  receive  all 
the  stock  except  what  preferred  stock  may  be  prescribed  for 
bonds  of  the  new  company  in  exchange  for  an  agreement  to 
construct  and  equip  its  loans  in  accordance  with  the  plans  and 
specifications  of  the  engineers,  which  are  made  part  of  the 
agreement.  At  the  time  this  contract  is  executed,  all  the 
common  stock  and  sometimes  such  a  portion  of  the  preferred  as 
may  not  have  been  provided  for  is  turned  over  to  the  construc- 
tion company,  together  with  a  small  amount  of  the  bonds. 
The  remainder  of  the  bonds  are  issued  to  a  trust  company, 
which  acts  as  trustee  for  the  holders,  in  installments  correspond- 
ing to  the  completion  of  sections  of  the  lines  as  certified  to  by 


CORPORATE  PROMOTION  165 

the  engineers  representing  the  trust  company.  The  promoter 
or  his  representative,  acting  for  the  construction  company, 
which  has  now  come  into  possession  of  all  the  securities  of  the 
new  corporation,  arranges  with  some  trust  company  or  bank 
to  advance  sufficient  funds  to  build  and  complete  the  line.  The 
security  offered  is  the  bond  issue  of  the  railroad  company  sup- 
plemented by  the  guarantees  above  mentioned  and  by  a  certain- 
amount  of  the  stock.  The  common  stock  of  the  railroad  com- 
pany, it  should  be  mentioned,  is  divided  up  among  the  guaran- 
tors of  the  bonds.  The  trust  company  advances  the  funds,  the 
banker  finally  sells  the  bonds,  and  what  remains  constitutes  the 
promoter's  profit.  The  amount  of  common  stock,  which  must 
be  given  to  each  one  of  those  interests,  and  that  can  be  re- 
tained by  the  promoter,  varies  with  circumstances.  In  return 
for  making  the  loan,  the  trust  company  usually  exacts  a  com- 
mission of  say  2%  per  cent  to  5  per  cent,  besides  the  regular 
interest  of  6  per  cent  or  in  some  cases  as  high  as  8  per  cent,  the 
loans  running  for  two  years.  This  money  is  advanced  on  serial 
notes  of  the  construction  company,  corresponding  to  the  comple- 
tion of  different  sections  of  the  road,  and  secured  by  the  bonds 
which  are  issued  to  the  construction  company  by  their  trustee  as 
fast  as  the  road  is  completed. 

For  example,  we  will  suppose  that  the  total  amount  of  bonds 
is  $1,000,000,  and  that  these  should  be  issued  in  ten  installments 
to  the  construction  company.  The  first  installment  of  $100,000 
is  issued  at  the  time  the  contract  with  the  railroad  company  is 
executed.  The  construction  company  takes  this  note  together 
with  the  guarantee  of  the  purchase  of  these  bonds,  and  $100,000 
of  bonds,  and  borrows  from  the  trust  company  $100,000.  With 
this  $100,000  it  pays  for  the  completion  of  five  miles  of  road. 
When  it  is  certified  to  the  trustee  of  the  bonds  that  this  mileage 
has  been  completed,  another  $100,000  of  bonds  is  issued,  an- 
other note  negotiated  and  in  this  way  by  serial  installments  and 
notes,  the  trust  company  in  time  advances  all  the  funds  neces- 
sary to  build  the  line.  Prior  to  the  completion  of  the  lines 
some  portion  of  the  interest  may  be  earned  by  the  sections  which 
may  be  put  into  operation.     It  is  customary,  however,  to  pro- 


166  CORPORATION  FINANCE 

vide  in  the  original  capital  issue  sufficient  funds  for  the  payment 
of  one  or  two  years'  interest. 

If  the  calculations  of  the  promoter  have  been  correct,  after 
the  company  has  completed  its  first  full  year  of  operations, 
little  difficulty  will  be  experienced  in  arranging  for  an  advan- 
tageous sale  of  the  bonds  to  the  city  banker.  Some  stock  may 
be  demanded  along  with  these  bonds,  but  the  amount  will  be 
small  compared  with  what  would  have  been  asked  if  the  banker 
had  been  obliged  to  advance  the  money  for  construction.  In 
agreeing  to  take  the  bonds  of  an  interurban  electric  railway  the 
banker  is  running  httle  risk,  and  is  often  able  to  dispose  of  all 
the  bonds  as  soon  as  he  has  completed  his  payments  for  them. 
These  bonds,  until  the  notes  which  have  been  secured  have  been 
paid,  remain  in  the  custody  of  the  trust  company  which  ad- 
vances the  money  to  the  construction  company  as  fast  as  the 
bonds  are  delivered  to  the  banker.  He  makes  payment  for  them, 
and  with  these  funds  the  notes  of  the  construction  company 
are  satisfied  and  all  the  bonds  have  been  taken  up  and  paid  for ; 
the  indebtedness  of  the  construction  company  is  discharged,  and 
there  remains  in  its  hands  a  certain  amount  of  cash  and  securi- 
ties which  are  distributed  to  its  stockholders.  The  construc- 
tion company's  work  having  been  accomplished,  it  is  then  dis- 
solved. 


i 


CHAPTER  XIII 

THE  PROMOTER  AND  THE  CORPORATION 

87.  Professional  promoters. — It  is  time  to  say  some- 
thing about  the  promoter,  his  personality,  his  duties,  his 
legal  responsibilities,  the  services  that  he  performs  and 
the  pay  that  he  receives.  Readers  who  are  unfamiliar 
with  the  world  of  finance  may  have  assumed  from  what 
has  been  said  that  a  certain  class  or  group  of  men  make 
it  their  sole  business  to  promote  enterprises  and  that  no 
one  else  ventures  into  this  field.  This  would  be  an  en- 
tirely erroneous  impression.  Anyone  who  is  pushing  a 
money-making  scheme  is  a  promoter  for  the  time  being, 
or  at  least  he  is  performing  some  of  the  functions 
of  a  promoter.  On  the  other  hand,  as  not  everyone  by 
any  means  is  well  fitted  by  temperament,  training  or 
practice  to  make  a  success  of  the  difficult  work  of  pro- 
motion, comparatively  few  men  are  concerned  with  such 
work  to  any  great  extent. 

We  may  classify  the  men  who  spend  a  considerable 
amount  of  their  time  and  energy  in  promotion  into 
four  groups.  Let  it  be  clearly  understood,  however, 
that  this  classification  does  not  pretend  to  be  com- 
plete. 

First  come  the  professional  promoters,  the  men  who 
really  do  make  it  their  main,  and  almost  their  sole,  busi- 
ness to  hunt  for  enterprises  that  promise  profits  and  to 
finance  those  enterprises.  This  type  is  common  in  fic- 
tion, but  rare  in  real  life.  So  far  as  the  writer  recalls, 
he  has  met  only  one  man  who  could  be  put  in  this  class, 

167! 


168  CORPORATION  FINANCE 

a  tall,  lank,  fervent  individual  with  a  persuasive  air. 
At  the  time  the  writer  knew  him  he  was  engaged  in 
selhng  the  stock  of  a  Mexican  rubber  plantation  com- 
pany; he  was  also  interested  with  others  in  the  de- 
velopment of  a  tract  of  real  estate  near  New  York  City ; 
and  he  was  investigating  the  possibilities  of  a  copper 
mine  in  North  Carolina.  No  doubt  other  plans  were 
germinating  in  his  mind.  He  was  of  the  enthusiastic, 
visionary  type,  utterly  incompetent  to  manage  an  enter- 
prise, but  skillful  in  appealing  to  the  aspirations  and 
emotions  of  others.  On  the  whole,  he  was  fairly  suc- 
cessful ;  that  is  to  say,  he  was  making  enough  money  on 
one  enterprise  to  pay  his  losses  on  the  others  and  to  get 
a  decent  living  in  the  bargain.  He  was  unquestionably 
honest  in  his  convictions ;  indeed,  it  was  easy  for  him  to 
be  honest,  for  he  possessed  a  mind  that  readily  believed 
whatever  he  wished  to  believe.  Probably  he  was  used 
as  a  tool  in  many  cases,  although  he  never  suspected  it, 
by  shrewder  and  less  scrupulous  men. 

It  might  be  said  that  Mr.  John  W.  Gates,  Judge  W. 
H.  Moore,  Mr.  Daniel  G.  Reid,  and  the  others  named 
in  Chapter  XII,  are  professional  promoters.  It  would 
be  more  nearly  correct,  however,  in  the  writer's  opinion 
to  classify  these  men  as  primarily  brokers,  or  lawyers, 
or  bankers,  who  have  won  a  few  great  successes  in  the 
field  of  promotion,  ^he  man  who  does  nothing  but 
"promote"  is  not  apt  to  achieve  marked  successes,  one 
reason  being  that  the  really  great  opportunities  are  not 
usually  stumbled  upon  by  chance  or  disclosed  to  those 
who  seek  after  them,  but  are  revealed  only  to  those  who 
have  an  intimate  acquaintance  with  the  details  of  the 
business  to  be  promoted.  The  only  exception  to  this 
statement  worth  noting  is  when  one  who  has  already 
achieved  success  as  a  promoter  is  called  in  by  men  who 


1 


PROMOTER  AND  CORPORATION  169 

thoroughly  understand  the  business  to  be  promoted  and 
who  place  their  knowledge  at  his  disposal. 

88.  Lawyers  and  hankers  as  promoters, — The  second 
class  consists  of  lawyers  and  bankers  in  small  commu- 
nities. Such  men  have  exceptional  opportunities  to  in- 
form themselves  as  to  local  conditions;  they  frequently 
take  hold  of  some  local  enterprise,  such  as  a  steam  or 
street  railway,  secure  the  assistance  of  experts  for  inves- 
tigation and  carry  through  the  proposition  to  success. 
Still  more  frequently,  however,  so  far  as  the  writer  has 
observed,  such  men  underestimate  the  difficulties  of  the 
problem ;  they  take  it  up  with  enthusiasm  but  are  forced 
either  to  drop  it  or  to  call  in  men  of  wider  experi- 
ence. 

The  men  to  whom  they  generally  turn  constitute  the 
third  class  of  promoters,  namely  the  larger  bankers  and 
brokers.  The  amount  of  promotion  work  performed 
by  such  men  is  limited  and  they  usually  confine  their 
active  participation — except  for  advice — ^to  the  financ- 
ing of  such  enterprises  as  they  take  up.  Mr.  J.  Pier- 
pont  Morgan  stands  out  as  the  most  prominent  example 
of  this  class. 

89.  Engineering  firms  as  promoters, — The  fourth 
class — and  this  is  a  recent  important  development — 
consists  of  engineering  firms  engaged  in  construction 
work  of  various  kinds.  Certain  Targe  engineering  con- 
cerns have  established  a  wide  reputation  for  success  in 
operating  street  railroads,  water  works,  electric  lighting 
plants,  and  so  on.  These  firms  naturally  have  built  up 
a  large  and  well-equipped  staff  of  experts  in  those  fields. 
As  the  staff  is  expensive,  it  becomes  a  pressing  problem 
to  keep  them  profitably  employed  all  the  time.  In  the 
effort  to  solve  this  problem  such  firms  have  drifted 
into  the  custom  of  taking  up  new  enterprises  of  merit 


170  CORPORATION  FINANCE 

and  performing  the  work  of  promotion  themselves. 
Their  prime  object  in  so  doing  is  to  employ  their  own 
engineering  talents  and  the  abilities  of  their  staff  to  the 
best  advantage.  Incidentally,  of  course,  they  have  no 
objection  to  securing  some  of  the  other  returns  that 
naturally  follow  from  successful  promotion. 

These  engineering  promoters  have  three  great  ad- 
vantages which  have  told  heavily  in  their  favor: 

(1)  They  are  able  to  carry  on  a  thorough  investiga- 
tion of  any  project  that  is  presented  to  them  without 
much  extra  expense ;  and  as  they  are  constantly  engaged 
in  siich  investigations,  they  have  developed  a  body  of 
experts  who  are  able  to  give  the  best  possible  judgment 
as  to  the  outlook  for  success  in  each  instance.  Conse- 
quently, they  seldom  go  wrong. 

(2)  They  are  almost  invariably  big  enough  and  have 
resources  enough  to  finance  the  projects  which  they 
undertake  themselves,  if  necessary.  However,  as  they 
are  primarily  engineers,  not  financiers,  they  nearly  al- 
ways prefer  to  secure  the  greater  part  of  the  funds 
from  other  persons.  This  they  accomplish  by  calling 
to  their  assistance  some  large  banking  and  brokerage 
house,  which  will  undertake  to  sell  the  securities  of  the 
corporations  organized  by  the  engineering  firms.  The 
alliance  thus  formed  is  of  great  advantage  to  the  bank- 
ing house,  inasmuch  as  it  may  accept  with  confidence 
the  results  of  the  investigation  carried  on  by  the  engi- 
neering firm's  experts. 

(3)  The  engineering  firm,  having  a  reputation  to 
acquire  and  sustain,  does  not  desert  the  new  enterprise 
as  soon  as  financed,  as  most  promoters  do,  but  sticks  with 
it  until  it  is  a  thoroughly  established  success.  The  en- 
gineering firm  must  have  on  its  staff  experts,  not  only 
in  planning  and  building  the  street  railroad  or  power 


PROMOTER  AND  CORPORATION  171 

plant  or  whatever  the  new  project  may  be,  but  also  in 
operating  the  enterprise.  It  is  in  position,  therefore, 
not  merely  to  put  the  new  corporation  on  its  feet,  but 
to  give  it  a  good  running  start  toward  success.  Further- 
more, if  the  corporation  later  gets  into  difficulties,  the 
engineering  firm  may  be  relied  upon  to  come  to  its  as- 
sistance. 

With  these  advantages  there  is  no  telling  how  far 
the  tendency  toward  promotion  by  engineering  firms 
will  go.  It  would  not  surprise  the  writer  to  see  almost 
all  business  of  this  kind  except  the  largest  projects 
turned  over  by  common  consent  within  the  next  few 
years  to  the  well-established  engineering  firms.  No 
doubt,  as  soon  as  this  tendency  becomes  well  known, 
cheap  imitators  of  the  reliable  engineering  concerns  will 
come  into  the  field.  This  difficulty,  however,  can  be 
overcome,  and  in  the  end  we  shall  perhaps  find  the 
business  of  promotion  cleaner,  more  reputable  and  con- 
ducted with  greater  abiUty  than  under  present  condi- 
tions. 

90.  Secret  profits  are  illegal. — No  matter  who  the 
promoter  of  any  particular  enterprise  may  be,  it  is  al- 
ways necessary  for  him  to  raise  funds  from  outsiders 
for  his  new  corporation;  and  in  the  process  of  raising 
funds  he  must  make  representations  as  to  the  standing 
and  prospects  of  the  corporation.  He  also  frequently 
enters  into  contracts  on  behalf  of  the  corporation  to  be. 
His  activities  in  both  directions  frequently  raise  knotty 
legal  questions,  which  it  is  important  for  us  to  notice. 

At  law  a  promoter  is  in  an  anomalous  situation,  so 
far  as  his  relation  to  his  corporation  is  concerned.  He 
is  not,  strictly  speaking,  an  agent,  because  an  agent 
must  have  a  principal  and  the  company  promoted  can- 
not be  a  principal  because  it  is  not  yet  in  existence; 


172  CORPORATION  FINANCE 

yet  the  courts  have  held  that  his  activities  in  many 
respects  are  analogous  to  those  of  an  agent.  In  addi- 
tion, a  promoter  is  in  a  sense  a  trustee  of  the  interests 
of  the  corporation  that  he  is  organizing.  He  is  under 
obligations  to  do  his  best  for  the  corporation  and  to  act 
always  in  good  faith  for  its  benefit.  Furthermore,  he 
must  disclose  all  the  pertinent  facts  in  connection  with 
the  contracts  and  bargains  that  he  makes  for  the  cor- 
poration to  its  officers  and  stockholders  when  formed. 
Generally  speaking,  secret  profits  and  fraud  on  the  part 
of  the  promoter  are  not  merely  immoral,  but  are 
regarded  by  the  courts  as  illegal  as  well.  Where  such 
transactions  are  discovered  the  corporation  may  bring 
suit  and  recover  damages.  The  four  cases  given  in 
abstract  below  illustrate  different  phases  of  this  prin- 
ciple. 

1.  B  agreed  to  sell  land  to  X  and  Y,  promoters  of 
a  corporation,  for  $12,000.  He  then  associated  him- 
self with  them  and  the  three  agreed  to  form  a  corpo- 
ration which  should  buy  the  land  for  $40,000,  out  of 
which  B  was  to  receive  the  $12,000  he  had  originally  de- 
manded and  in  addition  one-third  of  the  profits  of  pro- 
motion. The  company  was  formed,  the  purchase  price 
of  $40,000  paid  and  the  stock  of  the  company  sold  to 
outsiders.  Subsequently  the  facts  were  discovered  and 
the  company  filed  a  bill  against  the  administrator  of 
B's  estate  for  the  funds  which  B  had  received  over  and 
above  $12,000,  the  ground  of  action  being  that  B,  as 

a  promoter,  was  not  entitled  to  make  a  profit  by  a  sale^ 
of  his  land  to  the  company  at  a  fictitious  value.     The 
Supreme  Court  of  Pennsylvania  ordered  a  refund  to 
the  company  of  the  amount  received  above  $12,000. 

2.  B  and  C  with  the  object  of  incorporating  a  mining | 
company  purchased  oil  lands  for  $10,000,  and  united] 


PROMOTER  AND  CORPORATION  173 

in  organizing  a  company  to  buy  the  lands  for  $81,000. 
It  was  represented  to  prospective  shareholders  that  B 
and  C  had  purchased  in  the  interest  of  the  company 
and  that  the  price  paid  by  the  company  was  the  same  as 
that  paid  by  B  and  C  to  the  original  owners.  The  cor- 
poration sued  B  and  C  to  recover  the  difference  between 
the  price  paid  in  the  first  instance,  and  the  figure  at 
which  the  property  was  turned  over  to  the  corporation, 
and  the  suit  was  successful. 

3.  In  a  recent  New  York  case  it  was  shown  that  a 
promoter  joined  with  the  owner  of  a  tract  of  land  in 
procuring  options  of  doubtful  validity  on  adjoining 
tracts.  The  promoter  then  organized  a  corporation  to 
purchase  the  land  at  an  advanced  price  under  an  agree- 
ment with  the  owner  that  the  profits  thus  secured  were 
to  be  shared  equally.  The  promoter  bought  the  land 
for  $66,223,  though  the  deed  to  him  recited  $80,000  as 
the  purchase  price,  and  conveyed  the  land  to  the  cor- 
poration for  $80,000  and  400  shares  of  stock.  He  sold 
the  stock  to  other  stockholders  and  kept  for  himself 
the  $13,777  profit.  All  of  the  money  paid  to  the 
original  owners  of  the  land  belonged  to  the  corporation. 
It  was  held  that  the  corporation  was  entitled  to  the 
$13,777  profits. 

4.  The  promoters  of  a  plantation  company  purchased 
land  in  Cuba  for  $40,000  and  secured  an  option  on  addi- 
tional land  so  drawn  that  it  appeared  they  paid  $20,000 
for  the  option,  making  the  total  purchase  price  appear 
to  be  $60,000.  In  fact,  nothing  had  been  paid.  They 
organized  a  corporation  and  represented  to  their  associ- 
ates that  the  plantation  cost  $60,000.  They  assigned 
their  option  to  the  corporation,  taking  $2,000  in  stock  as 
their  share.  Their  associates  retained  the  balance  of  the 
stock.     It  was  held  that  the  promoters  were  under  a  fidu- 


174  CORPORATION  FINANCE 

ciary  relation  to  the  corporation  and  that  the  corporation 
was  entitled  as  against  them  to  the  cancellation  of  the 
stock  so  issued  to  them. 

It  should  be  understood  that  there  would  be  neither 
legal  nor  moral  objection  to  a  promoter's  sale  of  prop- 
erty to  his  corporation  at  a  higher  price  than  he  paid 
for  it.  The  only  obligation  resting  on  him  is  that  he 
should  not  conceal  his  profits.  In  practice  it  is  very 
difficult  to  prevent  concealment  and  the  promoter  may 
readily  find  methods  of  making  sworn  statements  as 
to  his  profits  that  will  be  true,  so  far  as  they  go,  but 
will  not  be  the  whole  truth.  A  scheme  much  used  in 
buying  property  that  is  later  to  be  sold  to  the  pro- 
moter's corporation  is  to  have  it  passed  from  the  original 
owners  first  to  another  corporation  owned  by  the  pro- 
moter or  to  a  friend  of  the  promoter;  then  this  corpo- 
ration or  friend  will  sell  to  the  promoter  at  a  price  far 
in  advance  of  what  was  paid  to  the  original  owner  and 
the  promoter  will  be  able  to  assert  that  he  turns  it  over 
to  the  corporation  he  organizes  at  cost  to  himself  or  at 
a  very  small  profit.  Sometimes  the  property  may  be 
made  to  pass  through  two  or  three  intermediate  hands 
in  order  to  make  detection  more  difficult. 

91.  Misleading  statements  constitute  fraud, — An- 
other feature  of  the  promoter's  work  which  should  be 
considered  relates  to  his  statements  with  regard  to  the  en- 
terprise whether  made  verbally,  in  correspondence  or  in 
prospectuses.  These  statements  are  subject  to  the 
general  principles  of  the  law  relating  to  fraud.  The 
promoter  is  bound  not  merely  to  make  his  statements 
accurate,  but  not  to  omit  any  facts  of  vital  importance. 

Of  course,  the  same  difficulties  that  are  found  in  all 
applications  of  the  law  relating  to  fraud  are  evident 
here.     The  promoter  may  state  what  he  considers  to 


PROMOTER  AND  CORPORATION  175 

be  the  facts  and  may  omit  features  that  he  considers 
non-essential  and  it  would  be  impossible  to  prove  that 
his  motives  and  intent  were  not  of  the  best.  We  shall 
see  in  dealing  with  prospectuses  how  easy  it  is  to  give  a 
misleading  impression  without  actually  making  any 
misstatements. 

92.  Contracts  on  behalf  of  the  corporation  and  their 
acceptance, — Difficulties  sometimes  arise  in  connection 
with  the  contracts  which  a  promoter  makes  on  behalf 
of  his  proposed  corporation.  As  the  promoter  is  not 
an  agent,  he  has  no  right,  strictly  speaking,  to  act  in 
behalf  of  the  corporation.  Courts  of  equity,  however, 
have  modified  this  strict  rule  to  such  an  extent  that  the 
corporation  accepts  the  contract  by  accepting  its  bene- 
fits. Acceptance  need  not  be  expressed  in  words;  it 
may  be  reasonably  inferred  from  the  acts  of  the  corpo- 
rations. 

93.  The  promoter's  pay, — The  most  vital  questions 
that  arise  between  the  promoter  and  his  corporation 
are:  How  shall  the  promoter  be  paid  for  his  services? 
How  large  shall  his  profits  be?  The  promoter  usually 
feels  that  he  is  entitled  to  all  he  can  get.  The  corpo- 
ration's stockholders,  on  the  other  hand,  are  apt  to  be 
dissatisfied  even  with  a  compensation  that  the  promoter 
considers  exceptionally  small.  The  following  extract 
from  the  Report  of  the  Industrial  Commission  ^  states 
the  essential  facts. 

There  are  various  ways  for  the  promoter  to  receive  his  pay. 
In  certain  Instances,  as,  for  example,  the  United  States  Rubber 
Company,  the  promoter  received  for  his  work  5  per  cent  of 
the  total  stock  Issued,  but  had  to  pay  out  of  this  the  charges  of 
lawyers,  accountants,  appraisers,  and  bankers. 

A  more  usual  form  of  remuneration  Is  to  give  the  promo- 

1  Second  volume  on  "  Trusts  and  Industrial  Combinations,"  page  VIII. 


176  CORPORATION  FINANCE 

ter  a  certain  amount  of  stock  with  which  to  buy  the  plants  re- 
quired and  to  pay  expenses,  permitting  him  to  retain  the  surplus 
for  his  profits.  In  the  case  of  the  Rubber  Goods  Manufactur- 
ing Company  the  syndicate  subscribers  furnishing  cash  received 
for  each  $100  paid  in  $100  in  preferred  stock  and  $90  in  com- 
mon stock.  The  promoters  had  to  purchase  the  plants  and  were 
given  the  entire  issue  of  preferred  and  common  stock.  If  they 
could  buy  the  plants  for  the  proceeds  of  100  per  cent 
of  preferred  stock  and  90  per  cent  of  common,  they  made 
the  10  per  cent  of  common  stock  for  their  profit;  if  they  had 
to  pay  more  than  that  sum  their  profits  were  correspondingly 
lessened;  if  they  could  buy  for  less,  naturally  they  made  more 
than  the  10  per  cent  of  the  common  stock.  They  were  under 
the  express  limitation  that  no  preferred  stock  was  to  be  issued 
in  excess  of  tangible  assets,  and  no  common  stock  in  excess  of  an 
amount  determined  by  the  earning  capacity  of  the  plants,  as 
shown  by  previous  experience,  capitalized  on  a  7  per  cent  basis. 
In  the  case  of  the  American  Smelting  and  Refining  Company, 
syndicate  subscribers  for  each  $100  paid  in  cash  received  $100 
in  preferred  stock  and  $70  in  common  stock.  The  promoters 
received  the  remaining  $30  in  common  stock,  out  of  which  they 
had  to  pay  the  entire  expenses  of  organization.  They  retained 
the  remainder  for  their  profits.  Speaking  generally,  Mr.  Chap- 
man states  that  when  a  financiering  syndicate  receives  for  its 
subscriptions  par  in  preferred  stock  and  something  less  than 
par  in  common  stock,  the  usual  custom  is  for  the  promoters  to 
receive  the  remainder  of  the  common  stock  as  pay  for  their  serv- 
ices and  for  covering  the  costs  of  organization.  In  most  cases 
their  profits  will  depend  upon  the  rigidity  with  which  they  can 
hold  down  their  expense  accounts,  and,  in  many  cases,  where  the 
purchase  of  plants  is  entirely  in  their  hands,  upon  the  skill  which 
they  can  show  in  making  purchases.  Usually,  of  course,  a  care- 
ful appraisement  has  been  made  of  plants  beforehand,  so  that 
the  basis  of  the  stock  issue  is  well  known  to  all  parties  inter- 
ested in  the  deal.  A  certain  speculative  chance  is  also  often 
given  to  the  promoters  through  the  fact  that  it  is  within  their 


PROMOTER  AND  CORPORATION  177 

discretion  to  buy  for  cash  or  stocks  as  they  can  best  make  agree- 
ments with  the  vendors.  In  that  case  they  can  sometimes  make 
much  better  bargains  for  themselves  by  paying  cash,  or,  on  the 
other  hand,  by  persuading  the  vendors  to  take  securities,  thus 
lessening  the  amount  of  cash  that  needs  to  be  paid  out.  It  is 
regularly  the  case  that  the  promoter  receives  his  pay  in  common 
stock. 

Within  the  last  two  or  three  years  there  seems  to  have  been  a 
more  conservative  tendency  shown  by  the  bankers  and  others 
interested  in  financing  the  industrial  combinations.  The  man 
who  advances  money  to  buy  the  various  plants  is,  In  many  in- 
stances, taking  a  considerable  risk  and  expects  often  to  secure 
high  pay  therefor.  The  extent  of  his  pay  is  dependent  never- 
theless largely  upon  his  judgment  as  to  the  future  course  of  de- 
velopment of  the  business  of  the  combination  in  question.  He 
practically  buys  securities  of  manufacturing  establishments. 
If  they  earn  high  dividends  his  earnings  will  be  great,  provided 
he  retains  the  securities;  if  he  sells  them  his  profits  will  be  de- 
termined by  the  market  rate  of  the  securities,  that  being  de- 
pendent again  in  the  long  run  upon  the  earning  capacity  of  the 
establishments.  The  more  usual  terms  probably,  under  which 
within  the  last  two  or  three  years  the  financial  agreements  have 
been  made,  are  that  for  each  $100  cash  paid  in  the  subscribing 
member  of  the  financial  syndicate  receives  par  in  preferred  stock 
with  a  bonus  in  common  stock  equal  to  the  preferred  less  the 
amount  reserved  for  the  pay  of  the  promoter.  This  reserve 
has  sometimes  been  as  high  as  50  per  cent  of  the  common  stock, 
sometimes  30  per  cent,  and  sometimes  only  10  per  cent. 

Instead  of  the  plans  mentioned  above  numerous  others  are  of 
course  found,  especially  where  it  is  more  desirable  to  issue  bonds 
or  where  for  some  reason  it  seems  desirable  to  make  special  terms, 
owing  to  the  peculiar  situation  of  some  of  the  members  entering 
into  the  combination.  Promoters  sometimes  receive  specified 
sums  of  money  for  their  services;  bankers  practically  always 
have  to  take  for  their  services  a  percentage  of  the  stock  or  th^ 
surplus  left  over. 
1—12 


178  CORPORATION  FINANCE 

94.  The  promoter  s  risks  and  labors, — Enough  has 
been  said  to  indicate  that  the  promoter's  labors  and  risks 
are  heavy.  If  he  does  his  work  thoroughly  he  will 
probably  spend  a  long  time  in  careful  investigation  of 
the  enterprise  and  in  examination  of  all  the  possible 
causes  of  failure  before  he  binds  himself  in  any  manner. 
If  he  is  a  man  of  sound  judgment,  as  he  must  be  in  order 
to  be  successful,  he  will  probably  find  serious  if  not  fatal 
flaws  in  most  of  the  enterprises  that  come  to  his  atten- 
tion. A  professional  promoter  must  expect,  therefore, 
to  spend  a  large  amount  of  time  and  money  in  studies 
and  investigations  that  bring  him  no  return.  Unless 
this  part  of  his  work  is  thoroughly  done  his  efforts  are 
foredoomed  to  failure. 

In  the  process  of  assembling  his  proposition,  the 
promoter  must  always  take  considerable  personal  risks. 
He  buys  options,  enters  into  contracts,  and  perhaps 
spends  money  for  further  experiment,  all  of  which 
will  be  absolutely  lost  unless  his  promotion  proves 
successful. 

In  financing  the  enterprise,  the  promoter  puts  in 
jeopardy  not  only  the  time  and  money  previously  ex- 
pended, but  his  business  reputation  as  well.  One 
notoriously  unsuccessful  promotion  will  probably  end 
a  promoter's  activities,  at  least  if  he  is  engaged  in  an 
entirely  legitimate  line  of  business. 

95.  Is  the  promoter  overpaid? — It  is  obvious  also 
that  the  promoter  must  possess  a  rare  and  highly  valu- 
able combination  of  talents.  He  must  be  keen,  shrewd, 
a  good  bargainer,  farsighted,  prudent,  enthusiastic, 
persuasive,  and,  above  all,  he  must  inspire  confidence. 
With  this  necessary  combination  of  talents,  labors  and 
risks,  it  is  not  surprising  that  the  promoter  should  sub- 
sequently claim  and  exact  large  profits.     It  is  no  doubt 


PROMOTER  AND  CORPORATION  179 

true  that  a  considerable  number  of  men  who  have  won 
success  in  this  field  have  made  millions  and  tens  of 
millions  of  dollars  in  a  very  short  time.  To  the  on- 
looker it  sometimes  appears  that  these  millions  almost 
came  dishonestly,  that  it  is  hardly  possible  that  they 
are  legitimate  earnings.  The  average  on-looker,  how- 
ever, has  no  conception  of  the  amount  or  importance  of 
the  preliminary  work  which  the  promoter  performs. 
Neither  has  he  any  conception  of  the  large  number  of 
failures  in  this  field.  Probably  the  losses  of  promoters, 
who  have  spent  their  own  time  and  both  their  own  and 
their  friends'  money  without  benefit  to  themselves, 
would  almost  equal  or  perhaps  exceed  the  total  profits 
of  successful  promotions. 

We  must  not  forget  to  consider  also  the  great  im- 
portance to  business  and  industry  of  their  achievements. 
They  are  the  men  who  have  found  and  developed  the 
inventions,  the  improvements  and  the  better  organiza- 
tion of  industry  which  underlie  our  modern  prosperity. 
Frequently  the  inventor  complains  that  he  has  made 
less  out  of  his  invention  than  did  the  business  promoter; 
the  manufacturer  complains  that  with  all  his  years  of 
effort  he  has  made  less  out  of  his  factory  than  did  the 
promoter  who  takes  it  into  a  big  consolidation ;  the  mine 
owner  complains  that  he  has  made  less  out  of  his  land 
and  ore  than  did  the  promoter  who  obtained  the  funds 
for  its  developments.  All  of  these  complaints  are 
natural  enough;  yet  they  all  alike  fail  to  take  into  ac- 
count the  obvious  fact  that  the  promoter's  efforts  have 
not  done  them  harm,  but  good.  He  has  performed 
for  each  of  them  a  great  service ;  and  even  if  he  retains 
the  larger  part  of  the  profits,  they  have  no  just  ground 
for  complaint. 


CHAPTER  XIV 

CORPORATE  PROMOTION— FORMING 
CONSOLIDATIONS 

96.  The  importance  of  small  industrial  combinations, 
— Of  late  years  the  most  conspicuous  and  perhaps  the 
most  important  field  for  promoters  has  been  the  con- 
solidation of  manufacturing  and  railroad  companies. 
The  tendency  toward  consolidation  has  been  even  more 
widespread  in  the  last  few  years  than  has  appeared  to 
the  casual  observer.  Popular  attention  has  been 
directed  almost  exclusively  to  what  is  called  the  trust 
movement,  that  is,  the  combinations  of  big  companies 
with  a  view  to  controlling  prices. 

Of  still  greater  importance,  however,  to  the  average 
business  man  has  been  the  tendency  toj3onsolidat£.  small 
local  plants,  not  for  the  sake  of  achieving  even  a  partial 
monopoly,  but  for  the  sake  of  the  economies  that  result 
from  manufacture  on  a  larger  scale  Ihan  is  possible  by 
a  small  partnership  or  corporation.  Among  the  most 
important  economies  that  may  be  thus  affected  are: 
first,  the  elimination  of  _wastef ul  competition  in  selling 
and  advertising ;  second,,  the  ^ppoijbunity  to  use  expen- 
sive  and  highly  specialized _machinery^more  constantly 
and  thereT)y  prevent  the  loss  that  results  from  allowing 
such  machinery  to  lie  idle;  tjmxl^a  position  of  greater 
advantage  to  business  managers  in  their  dealings_JBdth 
labor  unions;  fourth,  bringing  to  bear  the  best  brains, 
and^eXperience  to  be  found  in  any  Qf_the  plants  con- 
solidated on  the  problelns^f  eaclTplant. 

No  statistics  have  been  or  could  be  collected  to  show 

180 


FORMING  CONSOLIDATIONS  181 

exactly  the  extent  of  this  movement.  It  is  certain, 
however,  that  the  great  mass  of  the  manufacturing 
capital  of  the  United  States  is  now  employed  by  such 
consolidations  and  that  the  position  of  the  small  isolated 
manufacturer  is  daily  becoming  more  precarious.  In- 
deed, this  result  is  inevitable,  for  the  consolidation  can 
usually  effect  the  economies  mentioned  above  without 
equally  great  disadvantages.  The  consolidation,  there- 
fore, although  it  may  have  no  monopoly  and  no  control 
over  prices,  either  of  raw  materials  or  of  finished 
products,  easily  undersells  its  small  competitors.  It  is 
not  worth  while  to  rail  against  such  a  movement;  busi- 
ness men  will  do  better  to  recognize  its  inherent 
strength  and  get  into  line. 

97.  Difficulties  in  the  promoter's  task, — The  forma- 
tion of  a  consolidation  through  the  medium  of  a  holding 
company,  which  is  the  usual  form,  is  by  no  means  an 
easy  task.  It  brings  into  play  all  the  shrewdness, 
persuasiveness  and  business  judgment  that  a  promoter 
may  possess.  Usually  managers  and  owners  of  the  vari- 
ous plants  to  be  taken  into  the  proposed  consolidation 
are  so  mutually  jealous  and  antagonistic  that  it  is  next 
to  impossible  for  any  one  of  them  to  effect  a  friendly 
combination  with  all  his  competitors.  Once  in  a  while 
a  successful  manufacturer  may  buy  outright  the  securi- 
ties, or  perhaps  the  physical  assets,  of  competing  plants ; 
but  this  is  an  exception.  Usually  the  promoter  of  a 
consolidation  must  come  from  the  outside.  He  will 
probably  be  better  off  if  he  has  had  no  connection  with 
the  business  and  therefore  has  no  grudges  and  no  prej- 
udices to  overcome.  Sometimes  the  outside  promoter  is 
a  banker  friendly  with  all  the  interests  to  be  combined; 
sometimes  he  is  a  well-known  promoter  who  has  made 
a  name  for  fair  dealing  and  success;  sometimes  he  is  a 


18^  CORPORATION  FINANCE 

security  holder  in  one  or  more  of  the  concerns  to  be  con- 
solidated, who  has  taken  no  active  part  in  their  manage- 
ment. He  will  of  necessity  have  constantly  at  his 
command  the  expert  knowledge  of  men  directly  con- 
cerned with  the  business. 

For  the  sake  of  simplicity  we  will  first  consider  the 
process  of  consolidating  two  or  more  small  independent 
partnerships  or  corporations  into  a  somewhat  larger 
combination  of  some  local  importance ;  and  after  that  we 
will  consider  the  still  more  complicated  problems  that 
arise  in  the  process  of  forming  a  big  "trust" — using 
that  word  in  the  popular  sense — a  combination  of 
previous  consolidations. 

98.  "Discovery"  of  a  small  consolidation, — In  organ- 
izing a  small  consolidation  the  promoter's  first  step, 
as  has  already  been  indicated,  must  be  a  thorough  inves- 
tigation of  all  the  concerns  which  are  to  be  included. 
Usually  the  promoter  will  not  have  the  time  or  the 
facilities  to  undertake  such  an  investigation  personally 
or  by  means  of  his  own  assistants.  But  he  should 
certainly  be  unwilling  to  accept  the  unsupported  state- 
ments of  the  manufacturers;  he  will,  therefore,  use  the 
services  of  competent  engineers,  of  expert  public 
accountants  and  perhaps  of  lawyers.  The  accountants' 
examination  should  produce  the  most  important  and 
significant  results,  and  on  these  results  the  terms  of  the 
consolidation  will  probably  be  based. 

The  accountant's  work  in  this  connection  should  be 
even  more  extensive  and  searching  than  in  the  case  of 
a  regular  audit.  This  is  particularly  true  because  the 
managers  in  the  case  of  an  audit  presumably  desire  a 
correct  report;  in  the  case  of  this  special  investigation 
their  interests  lead  them  to  favor  over-valuation  of 
assets,  fictitious  accounts  receivable  and  a  padded  in- 


FORMING  CONSOLIDATIONS  183 

come  statement.  The  accountant  must  get  an  accurate 
physical  inventory  of  the  property,  if  possible;  he  must 
verify  the  accounts  and  bills  receivable  as  well  as  the 
accounts  and  bills  payable;  he  should  look  into  all  in- 
direct and  contingent  liabilities  with  great  care ;  he  must 
see  that  sales  do  not  include  goods  sent  out  "on  con- 
signment" and  "on  approval"  and  that  profits  are  not 
swelled  by  sales  of  what  are  in  reality  capital,  not 
current,  assets. 

99.  Basis  of  consolidation, — The  promoter's  next 
step,  if  he  is  acting  not  simply  on  his  own  account,  but 
as  a  sort  of  arbitrator  for  the  various  manufacturers, 
each  one  of  whom  is  willing  to  go  into  the  consolidation 
on  reasonable  terms,  is  to  draw  up  a  tentative  "basis  of 
consolidation."  In  an  article  in  The  Journal  of 
Accountancy  for  November,  1908,  Mr.  F.  H.  Mc- 
Pherson,  F.  C.  A.,  gives  in  illustration  the  following 
informal  memorandum  of  agreement  which  was  used  as 
a  basis  in  a  certain  consolidation  of  small  companies  with 
which  he  was  concerned.  The  agreement  is  typical  and 
is  well  worth  careful  reading.     It  is  given  in  full  below : 

Basis  of  Consolidation: 

A  corporation  to  be  formed  under  the  laws  of  the  State  of 
Michigan,  with  a  paid-up  capital  of  ten  million  dollars,  to  be 
apportioned  into  6  per  cent  preferred  stock  and  common  stock, 
as  the  parties  interested  may  hereafter  determine. 

This  corporation  to  purchase  all  the  assets,  property,  good- 
will, etc.,  of  all  the  four  companies  and  to  pay  therefor  in  pre- 
ferred and  common  stock  and  by  an  assumption  of  the  indebted- 
ness of  each  company. 

The  amount  of  preferred  and  common  stock,  to  be  paid  to 
each  company,  to  be  determined  by  the  value  of  the  net  tangible 
assets  and  the  valuation  placed  upon  the  earning  power  of  each 
company. 


184  CORPORATION  FINANCE 

In  placing  a  value   upon  the  tangible   assets,  same  to  be 
reached  as  follows : 

(1)  The  land,  buildings,  machinery,  tools,  and  patterns,  to  be 
determined  by  appraisers,  to  be  chosen  by  a  majority  of  a 
committee  made  up  of  one  appointed  by  each  of  the  com- 
panies ;  on  failure  of  this  committee  to  agree  on  appraisers 
the  selection  to  be  left  to  the  committee  who  present  these 
suggestions. 

(2)  Inventories  of  raw  materials,  work  in  progress  and  manu- 
factured stock  to  be  taken,  and  valuations  placed  thereon 
by  the  individual  companies,  and  this  to  be  done  under  the 
supervision  of  a  disinterested  party,  to  be  named  by  the 
committee. 

The  inventories  are  to  be  made  as  of  the  same  date,  and  to  be 
taken  at  substantially  the  same  time. 

When  completed  the  inventories  are  to  be  passed  and  agreed 
upon  by  a  committee  consisting  of  a  representative  of  each 
of  the  companies  and  one  to  be  named  by  the  committee. 
The  decision  of  these  five  to  be  binding. 

(3)  In  reaching  the  value  of  the  earning  power  of  the  several 
companies,  consideration  is  to  be  given  to  the  following  de- 
tails : 

(a)  That  profits  are  incidental  to  the  business  and  have  not 
been  anticipated. 

(b)  To  the  charging  to  operating  expenses  of  items,  excep- 
tional or  unusual,  and  which  have  had  the  effect  of  reduc- 
ing profits  below  normal. 

(c)  The  effect  upon  the  earnings  of  the  money  paid  out  as 
interest  upon  borrowed  capital,  in  case  it  be  found  that 
the  borrowings  (loans)  made  by  the  several  companies 
are  disproportionate  to  each  other. 

(d)  That  all  charges  to  operating  expenses  are  proper 
charges  against  the  business  and  that  they  are  made  for 
and  during  the  proper  period. 

(e)  That  proper  and  reasonable  allowances  have  been  made 
for  repairs  and  renewals  and  that  these  have  been  charged 
against  earnings. 


FORMING  CONSOLIDATIONS  185 

(f )  That  charges  against  earnings  for  depreciation  are  ad- 
justed upon  an  equitable  basis. 

(g)  Such  other  matters  as  appear  from  an  examination  of 
the  accounts  and  which  would  prejudicially  affect  the 
earnings  of  any  of  the  companies,  either  advantageously 
or  disadvantageously. 

(h)  The  value  of  the  earning  power  to  be  determined  by  a 
consideration  of  the  business  done  by  each  of  the  several 
companies  for  the  three  years,  1903,  1904  and  1905. 

(i)  Accountants  to  be  selected  by  the  committee  and  ques- 
tions which  may  arise  as  to  treatment  of  various  matters 
and  about  which  there  is  difference  of  opinion,  to  be  de- 
termined by  the  committee. 

( j  )  All  costs  and  expenses  incurred  in  making  appraisals,  ex- 
amination of  accounts,  or  of  performing  the  other  duties 
in  connection  with  the  formation  of  the  proposed  new 
company  to  be  charged  to  and  borne  by  the  new  com- 
pany ;  should  the  new  company  not  be  formed,  then  such 
costs,  expenses,  and  disbursements  to  be  borne  by  the 
four  individual  companies  in  proportion  to  the  number 
of  men  employed  by  each. 

It  will  be  noted  that  the  agreement  just  cited  does 
not  specify  just  when  preferred  and  when  common  stock 
shall  be  paid  by  the  holding  company  for  the  securities 
of  the  subsidiary  companies.  One  very  common 
arrangement  is  set  forth  in  the  following  extracts  from 
another  actual  agreement  where  several  fair-sized  man- 
ufacturing corporations  and  partnerships  were  to  be 
consolidated.     This  agreement  provided: 

Each  vendor  executing  this  agreement  also  executes  and  de- 
livers a  schedule  of  the  entire  property,  which  it  sells  to  said 
purchaser,  setting  forth  briefly  the  various  classes  of  property, 
with  the  sufficient  description  of  the  several  items  of  real  estate, 
plant  and  movables  to  identify  the  same,  which  schedule  sets 
forth  the  value  of  the  entire  property  so  sold,  the  tangible  and 


186  CORPORATION  FINANCE 

intangible  property  in  separate  items,  the  tangible  property 
being  valued  as  prescribed  by  subdivisions  a  and  b  in  the  Method 
of  Appraisal  hereinafter  set  forth,  and  the  value  of  its  intangi- 
ble property  ascertained  and  certified  by  one  or  more  responsible 
public  accountants,  as  prescribed  by  subdivision  c  of  said 
Method  of  Appraisal,  together  with  a  statement  of  any  addi- 
tional facts,  and  of  the  valuations  based  thereon,  which,  in  the 
vendor's  judgment,  may  aid  the  Appraisal  Committee  in  exer- 
cising the  discretion  conferred  upon  it  by  subdivision  b  of  said 
Method  of  Appraisal.  The  valuations  of  the  tangible  and  in- 
tangible properties  so  made  by  each  vendor  shall  be  considered 
as  prima  facie  evidence  of  the  true  value  of  said  vendor's  prop- 
erty for  the  purposes  of  sale,  but  shall  in  no  case  be  controlling 
upon  the  Appraisal  or  Executive  Committee  hereinafter  ap- 
pointed, such  valuations  or  prices  being  subject  in  all  cases  to 
any  investigation  and  modification  which  the  said  committee  or 
committees  may  deem  that  justice  requires;  the  total  of  such 
valuations  as  verified  or  modified  according  to  the  terms  of  this 
agreement,  to  be  the  purchase  price  which  said  vendor  is  to  re- 
ceive for  its  entire  property  so  sold. 

PUECHASE    PRICE 

The  purchase  price  to  be  paid  to  such  vendor  for  the  property 
sold  by  it  to  the  purchaser  shall  be  the  total  value  of  its  tangible 
and  intangible  property  and  shall  be  paid  in  stock  of  the  pur- 
chaser at  par,  as  follows : — 

1.  Tangible  property  paid  for  in  preferred,  etc. 
Each  vendor  whose  net  earnings  for  the  six  months  ending 
July  1st,  1898,  amount  to  4  per  cent — that  is,  at  the  rate  of 
8  per  cent  per  annum — on  the  value  of  its  land  and  plant, 
ascertained  as  above,  shall  receive  preferred  stock  for  the  full 
value  of  all  its  tangible  property. 

Any  vendor  whose  net  earnings  for  the  said  period  of  six 
months  shall  amount  to  less  than  at  the  rate  of  8  per  cent 
per  annum  on  the  value  of  its  land  and  plant,  shall  receive  pre- 
ferred stock  to  the  amount  pf  twenty-five  times  its  mi  earn- 


FORMING  CONSOLIDATIONS  187 

ings  for  said  six  months;  and  the  balance  of  the  value  of  said 
tangible  property  it  shall  receive  in  common  stock. 

Each  vendor  has  upon  its  schedule  set  forth  a  statement  of 
its  net  earnings  for  said  period,  which  is  subject  to  modification 
by  said  committee  under  the  above  rules  applicable  thereto. 

2.  Intangible  property  paid  for  in  common  stock. 

The  entire  value  of  the  intangible  property,  ascertained  as 
per  this  agreement,  shall  be  paid  by  the  purchaser  in  its  com- 
mon stock  at  par. 

Simultaneous  with  the  sale  and  transfer  of  its  properties  each 
vendor  shall  receive  from  the  purchaser  in  stock,  or  if  permanent 
certificates  are  not  ready,  then  scrip  for  the  same,  one-half  of 
the  purchase  price  to  which  it  claims  to  be  entitled  by  its 
schedule,  less  an  amount  of  preferred  stock  equal  to  125 
per  cent  of  its  mortgage  indebtedness,  if  any,  and  the  re- 
mainder of  said  stock  shall  be  withheld  by  the  purchaser  until 
the  exact  amount  of  the  purchase  price  shall  have  been  finally 
determined  as  herein  provided,  whereupon  the  vendor  shall  be- 
come entitled  to  the  remainder  of  the  purchase  price,  but  the 
purchaser  may  out  of  such  remaining  stock  retain  an  amount 
thereof  sufficient  to  secure  it  against  any  defective  title  and 
against  any  indebtedness  which  is  not  otherwise  sufficiently  pro- 
vided for. 

APPEAISAL,    ETC. 

Each  vendor  expressly  covenants  and  agrees  that  the  prop- 
erty set  forth  by  it  in  its  schedule  has  been  fairly  and  honestly 
valued  in  accordance  with  the  following  rules  and  methods,  which 
shall  be  the  rules  and  methods  to  govern  the  Appraisal  and  Ex- 
ecutive Committees  in  their  verification  or  modification  of  the 
same. 

METHOD  OF  APPEAISAL. 

( 1 )    Tangible  Property. 
(a)    Land: 

Land  shall  be  separately  appraised  at  its  actual  value 
without  reference  to  plants  thereon,  and  consideration  shall  be 


188  CORPORATION  FINANCE 

given  to  special  adaptability  or  want  of  adaptability  to  the  busi- 
ness. 

Plants  shall  be  appraised  apart  from  the  bare  land  at  their 
value  to-day  to  a  going  concern  for  the  purpose  for  which  used, 
based  upon  present  cost  of  construction  at  the  same  places  re- 
spectively. No  vendor  shall  set  forth  in  its  schedule  any  unim- 
proved land  or  other  property  belonging  to  it  which  is  neither 
a  part  of  the  plant  of  such  vendor  nor  essential  in  the  operation 
of  the  same,  nor  shall  the  same  be  purchased  by  the  second  party. 

(b)   Materials,  Supplies  and  Manufactured  Product. 

These  shall  be  appraised  at  what  it  would  cost  to  replace 
the  same  at  the  place  and  date  of  the  transfer  of  the  same  to  the 
purchaser. 

(2).  Intangible  Property, 

(c).  Intangible  property  shall  be  appraised  by  multiplying 
by  ten  the  average  yearly  earnings  during  the  past  five  and  one- 
half  years,  which  shall  be  ascertained  as  follows : — 

In  order  to  arrive  at  the  earnings  of  the  property  sold  by 
each  vendor  and  to  determine  on  a  uniform  basis  fair  for  all,  the 
earning  power  of  the  property  so  sold,  each  vendor  shall  add  to 
its  net  profits  such  of  the  following  items  as  have  been  thereto- 
fore deducted  by  said  vendor  in  ascertaining  its  net  profits  dur- 
ing said  period. 

1.  Interest  on  indebtedness. 

2.  Insurance  of  any  description. 

3.  Arbitrary  items  of  depreciation  or  wear  and  tear  not  paid 
out  or  actually  incurred  as  a  debt,  and  all  items  of  new  con- 
struction. 

4*.  Also  salaries  and  compensation  paid  to  officers,  directors, 
partners,  trustees,  superintendents  of  departments  or  works,  gen- 
eral managers,  auditors,  cashiers  and  chief  accountants,  but  all 
wages,  salaries  and  compensation  paid  to  laborers,  servants,  fore- 
men, clerks  and  employees  in  subordinate  positions  shall  remain 
charged  against  earnings. 

5.  The  accountants  must  ascertain  the  amounts  expended  by 
each  of  said  vendors  for  repairs,  renewals  and  maintenance  of 
plant  which  have  been  deducted  from  earnings  during  said  period 


FORMING  CONSOLIDATIONS  189 

of  R\e  and  one-half  years,  and  the  said  amounts  so  ascertained 
are  set  forth  on  the  schedules  of  said  vendors. 

In  order  to  place  said  vendors  on  a  uniform  basis  as  to  the 
amounts  expended,  or  which  ought  to  have  been  expended,  for 
repairs,  renewals  and  maintenance  of  plant  and  charged  against 
or  deducted  from  the  earnings  during  said  five  and  one-half 
years  or  other  period,  each  vendor  shall  add  to  said  earnings  any 
amount  actually  expended  by  it  for  repairs,  renewals  and  main- 
tenance of  plant  which  it  has  heretofore  charged  against  and 
deducted  from  said  earnings,  and  there  shall  then  be  charged 
against  and  deducted  from  said  earnings  of  each  vendor  ascer- 
tained as  aforesaid,  annually  a  sum  equal  to  S  per  cent  of  the 
schedule  value  of  the  plant  of  said  vendor  completed  prior  to 
the  last  date  of  the  five  and  one-half  years  or  other  period  ap- 
plicable to  said  vendor. 

In  the  case  of  those  vendors,  if  any,  which  shall  not  have  kept 
a  separate  repair  account  the  amounts  expended  by  them  for 
repairs,  as  required  by  this  subdivision  shall  be  ascertained  as 
nearly  as  possible  by  the  accountants  and  the  committee  of  ap- 
praisal from  the  books  of  such  vendors  and  from  the  condition 
of  their  plants  and  otherwise,  and  in  default  of  information  to 
the  contrary  it  shall  be  assumed  that  they  have  expended  in  re- 
pairs a  sum  equal  to  3  per  cent  of  the  value  of  their  respective 
plants. 

Having  by  the  foregoing  methods,  ascertained  the  earnings, 
there  shall  thereupon  be  deducted  from  the  average  annual  earn- 
ings of  each  vendor  for  said  period,  a  sum  equal  to  5  per  cent 
(5%)  of  the  value  of  the  land  and  plant  sold  and  completed 
prior  to  the  last  date  of  the  five  and  one-half  years  or  other 
period  applicable  to  such  vendor,  and  the  balance  of  said  aver- 
age annual  earnings  so  ascertained  shall  be  deemed  for  the  pur- 
poses of  this  agreement  the  net  profits  of  the  respective  vendors 
to  be  severally  multiplied  by  ten  as  aforesaid. 

Provided,  however,  that  in  case  it  shall  be  found  that  the 
aforesaid  multiplier  of  ten  will  produce  a  grand  aggregate  of 
common  stock  greater  in  amount  than  the  grand  aggregate  of 
preferred   stock,   the   Executive   Committee   shall   choose   such 


190  CORPORATION  FINANCE 

lower  multiplier  as  will  limit  the  grand  aggregate  of  preferred 
stock. 

Provided,  further,  that  in  the  event  that  the  grand  aggregate 
of  the  average  annual  net  earnings  of  the  vendors,  ascertained 
as  aforesaid,  shall  be  found  to  exceed  12  per  cent  of  the 
total  value  of  the  tangible  property,  then  said  Executive  Com- 
mittee in  its  discretion  may  choose  such  multiplier  as  will  fix  the 
volume  of  common  stock  as  closely  as  may  be  at  an  amount  upon 
which  such  past  net  earnings  would  show  6  per  cent  applicable 
to  dividends  upon  such  common  stock  after  providing  for  the 
dividend  on  the  preferred  stock. 

And  thereupon  such  newly  chosen  multiplier  (whatever  the 
same  may  be)  shall  be  the  multiplier  to  be  used  in  the  case  of  each 
vendor. 

The  agreement  that  has  just  been  cited  in  part  de- 
serves careful  study.  As  the  extracts  given  are  self- 
explanatory,  however,  it  will  be  left  to  the  reader  to  work 
out  for  himself  the  exact  methods  employed  by  the  pro- 
moters, and  accepted  by  the  owners  of  the  plants  in 
determining  values.  The  substance  of  the  plan,  it  will 
be  seen,  is  that  tangible  property  is  to  be  represented  by 
preferred  stock  in  the  consolidation  and  additional 
earning  power  by  common  stock.  This  puts  the  consol- 
idation, so  far  as  capitalization  is  concerned,  on  a  con- 
servative basis.  The  same  plan,  slightly  modified,  is 
widely  used. 

100.  The  necessity  for  cash, — Having  investigated 
and  assembled  his  proposed  consolidation,  the  promoter 
must  next  arrange  for  its  financing.  It  may  be  said  at 
this  point  that  the  basis  of  consolidation  in  itself  finances 
the  new  consolidation,  inasmuch  as  it  provides  for  the 
exchange  of  the  consolidated  company's  securities  for 
the  subsidiary  companies'  securities.  This  financing  is 
not  sufficient,  however,  to  provide  for  the  needs  of  the 


I 


FORMING  CONSOLIDATIONS  191 

new  corporation.  Working  capital,  to  a  considerable 
amount,  must  certainly  be  obtained  or  the  new  corpora- 
tion will  plunge  at  once  into  bankruptcy.  Further- 
more, a  consolidation  almost  always  implies  changes  in 
methods  of  operation.  New  officers  must  be  appointed, 
old  ones  dismissed.  Some  of  the  plants  perhaps  will  be 
dismantled  or  put  on  part  time;  other  plants  will  be 
remodeled  and  refitted  with  expensive  modern  machin- 
ery. Frequently  the  whole  arrangement  of  the  plants 
and  processes  of  manufacture  will  be  reformed  in  order 
to  introduce  the  methods  that  belong  to  large  scale 
production.  All  of  these  changes  may  be  necessary  in 
order  to  obtain  the  economies  that  belong  to  combina- 
tions. They  may  and  probably  will  prove  wise  and  in 
the  end  highly  profitable.  At  the  moment  of  forming 
the  consolidation,  however,  they  call  for  large  amounts 
of  new  capital  funds  and  bring  to  the  front  some  of  the 
most  difficult  problems  of  financing  which  a  promoter 
has  to  face. 

101.  One  method  of  raising  cash, — Following  the 
basic  principles  outlined  in  Chapter  XII,  the  promoter 
of  a  small  consolidation  will  endeavor  to  raise  whatever 
cash  is  necessary  first  of  all  from  local  bankers  and 
financiers.  If  he  succeeds  in  obtaining  the  co-opera- 
tion of  these  men,  he  is  much  more  likely  to  find  his 
proposition  regarded  favorably  by  larger  banking  in- 
terests. Two  courses  are  now  open  to  him:  either  he 
may  issue  bonds  of  the  new  company,  which  will  not  be 
first  mortgage,  but  which  he  may  name  "first  and 
refunding"  or  "first  general"  or  "first  consolidated";  or 
he  may  try  to  sell  stock  in  addition  to  that  which  has 
been  given  to  the  owners  of  the  consolidated  plants. 
Either  course  has  its  disadvantages.  The  bond  issue 
probably  cannot  be  sold  on  advantageous  terms  because 


192  CORPORATION  FINANCE 

the  consolidation  must  necessarily  be  an  experiment  at 
the  beginning  and  even  its  best  securities  will  have  a 
speculative  character.  Furthermore,  in  many  cases  the 
promoter  will  find  the  property  of  the  subsidiaiy  com- 
panies akeady  mortgaged  so  that  the  bonds  of  the  con- 
solidated company,  whatever  title  he  may  pick  out  for 
them,  will  be  in  reality  junior  liens.  The  sale  of  stock 
is  undesirable  because  the  stock  issue  in  all  probability  is 
already  large;  it  has  to  be  large  in  order  to  make  the 
terms  offered  to  the  owners  of  the  subsidiary  plants 
sufficiently  attractive.  If  still  more  stock  is  issued  to 
be  sold  to  the  public,  it  will  be  very  difficult  to  pay 
dividends  even  on  the  preferred,  not  to  speak  of  the 
common.  This  result,  the  promoter  certainly  does  not 
desire.  He  has  promised  usually  heavy  cumulative 
dividends  at  once  on  the  preferred  stock  and  has  held 
out  hopes  of  early  dividends  on  the  common,  and  his 
reputation  is  staked  on  the  f ulffilment  of  these  predic- 
tions. Moreover,  he  is  himself  usually  a  large  holder 
of  the  common  stock. 

On  balancing  these  considerations,  the  promoter 
usually  finds  himself  strongly  inclined  to  favor  the  sale 
of  bonds  if  they  can  be  sold  at  any  reasonable  price. 
His  sanguine  temperament — for  that  kind  of  tempera- 
ment naturally  belongs  to  a  promoter — leads  him  to 
minimize  the  danger  of  increasing  the  new  corporation's 
fixed  charges  and  to  exaggerate  the  probable  profits. 
He  therefore  turns  to  local  bankers  for  assistance  in 
borrowing  the  necessary  funds.  Frequently,  as  the  first 
step,  he  has  the  corporation  put  out  a  bond  issue  under 
a  mortgage  of  the  limited  open-end  type.  The  pro- 
vision may  be,  and  often  is,  that  of  the  total  issue  one- 
half  shall  be  offered  for  sale  in  the  first  year,  one-fourth 
in  the  second,  and  one-fourth  in  the  third  year;  of  course. 


FORMING  CONSOLIDATIONS  193 

the  length  of  time  over  which  the  sale  is  spread  and  the 
corporation's  allotment  each  year  may  vary  indefinitely, 
depending  on  the  urgency  of  the  company's  need  for 
cash.  He  then  obtains  a  guarantee  from  local  finan- 
ciers, including  perhaps  some  of  the  banks,  to  take  the 
unsold  bonds  at  the  end  of  each  period  from  the  corpora- 
tion at  a  low  price  which  is  specified.  By  this  guarantee 
the  corporation  is  protected  from  an  absolute  failure  to 
secure  cash.  The  guarantors  must,  of  course,  be  paid, 
usually  by  a  considerable  commission  on  all  the  bonds 
that  are  sold.  This  kind  of  an  arrangement,  which  we 
will  consider  at  greater  length  later,  is  known  as  under- 
writing. 

The  promoter  may  now  take  his  bond-issue — or  part 
of  it,  if  he  has  been  able  to  get  the  sale  of  only  a 
part  guaranteed — to  a  friendly  bank  and  secure  a  short- 
time  loan,  using  the  bonds  as  collateral  security.  He 
has  thus  provided  for  the  immediate  cash  necessities  of 
the  new  company  at  the  beginning  of  its  existence.  As 
fast  as  he  can  sell  the  bonds,  he  pays  off  the  bank  loans 
and  thus  puts  the  corporation  in  a  stronger  financial 
position.  If  the  issue  is  entirely  successful,  the  corpo- 
ration will  soon  have  plenty  of  cash,  obtained  by  this 
bond  issue,  and  will  be  able  to  carry  out  the  improve- 
ments in  operation  which  are  expected  to  make  the 
consolidation  a  profitable  venture. 

The  essential  feature  of  this  plan,  it  will  be  noted,  is 
the  distribution  of  the  risk  among  several  different 
parties.  The  bank  is  well  protected  in  accepting  the 
bonds  as  collateral  by  the  guarantee  of  responsible 
parties  to  buy  the  bonds  at  the  end  of  a  certain  period, 
if  no  purchaser  willing  to  pay  a  higher  price  is  pre- 
viously foimd.  The  guarantors  usually  take  little  risk, 
for  the  price  of  the  bonds  to  them  is  made  low  enough  to 

1—13 


194f  CORPORATION  FINANCE 

be  attractive.  The  corporation  obtains  at  once  what- 
ever cash  is  necessary  and  its  only  risk  is  that  it  may  have 
to  sell  its  bonds  to  the  guarantors  at  a  low  price. 

Naturally  the  promoter  in  the  period  left  to  him 
before  the  guarantors'  option  becomes  effective  does  his 
best  to  sell  the  bonds  at  a  good  price.  The  methods 
which  he  uses  and  the  agencies  through  which  he  works 
are  fully  treated  in  later  chapters. 

102.  Problems  in  forming  a  large  consolidation. —  \ 
There  is  no  difference  in  principle  between  the  pro- 
moter's functions  in  forming  a  small  and  his  functions 
in  forming  a  large  consolidation.  He  is  doing  things 
on  a  bigger  scale,  however,  and  finds  necessary  several 
important  variations  in  his  methods. 

In  the  first  place,  such  a  consolidation  is  almost  always 
too  large  to  be  handled  by  any  one  man.  In  order  to 
reach  all  the  parties  concerned  and  to  inspire  confidence, 
it  is  generally  desirable  for  several  promoters  to  work 
together,  each  performing  a  portion  of  the  labor. 
When  the  United  States  Steel  Corporation  was  f  ornted, 
as  described  in  the  following  chapter,  almost  all  of  the 
prominent,  successful  promoters  of  the  country  were 
concerned  in  one  way  or  another.  Apart  from  the 
necessity  of  dividing  the  work  to  be  performed,  it  is  very 
desirable  to  promote  harmony  and  secure  the  best  solu- 
tions of  the  difficult  and  complicated  problems  involved 
in  such  a  consolidation  by  getting  the  ideas  of  a  con- 
siderable number  of  able  and  experienced  men. 

In  the  second  place,  the  promoter  or  group  of  pro- 
moters is  dealing  with  such  a  large  number  of  security 
owners  of  subsidiary  companies  that  lengthy  consulta- 
tion with  these  owners  and  bargain-making  is  out  of 
the  question.  Usually  the  heavy  stockholders  in  the 
subsidiary  companies  are  consulted  and  frequently  they 


FORMING  CONSOLIDATIONS  195 

have  some  part  in  the  scheme  of  promotion.  The  great 
mass  of  stockholders,  however,  are  simply  notified,  when 
the  proper  time  comes,  of  what  is  proposed  and  are  in- 
vited to  accept  the  offer  which  the  promoters  lay  before 
them. 

103.  Basis  of  consolidation. — The  amount  and  char- 
acter of  the  security  issues  of  the  proposed  consolidation, 
and  the  terms  upon  which  these  securities  will  be 
exchanged  for  the  securities  of  the  subsidiary  companies, 
are  fixed  by  the  promoters  in  advance.  This  does  not 
mean  that  the  terms  are  unfair  to  the  subsidiary  com- 
panies' stockholders.  On  the  contrary,  they  are  usually 
extremely  liberal.  It  must  be  remembered  that  it  is 
very  desirable  for  the  holding  company  to  have  all  the 
stock — certainly  all  the  voting  stock — of  each  sub- 
sidiary. The  less  subsidiary  company  stock  there  is 
left  outstanding,  the  less  is  the  chance  of  complaint  and 
annoying  legal  processes  on  the  part  of  the  dissenting 
stockholders  against  the  actions  of  the  holding  company. 
The  promoters,  therefore,  try  to  offer  such  terms  that 
all,  or  almost  all,  the  stock  of  subsidiary  companies  will 
be  exchanged  for  stock  of  the  consolidation. 

The  usual  arrangement  is  to  divide  the  capital  stock 
of  the  consolidation  into  preferred  and  common,  the 
amount  of  the  preferred  being  equivalent  to  the  total 
market  value  of  all  the  subsidiary  company  stock. 
Practically  any  amount  of  common  stock  may  be 
issued;  the  promoter  usually  puts  out  as  much  as  he 
thinks  can  possibly  obtain  dividends  within  a  reasonable 
number  of  years.  The  stockholders  of  the  subsidiary 
companies  are  then  offered  somewhat  more  than  the 
market  value  of  their  stock  payable  in  cash,  or  consid- 
erably more  than  its  market  value  payable  in  preferred 
stock.     If  they  take  preferred  stock,  they  will  ordinarily 


196  CORPORATION  FINANCE 

receive  in  addition  a  substantial  bonus  of  common  stock. 
The  first  proposition  is  intended  to  catch  the  ultra-con- 
servative; tlie  second  proposition  is  intended  to  be  even 
more  attractive.  ^  The  stockholder  is  to  receive  in  place 
of  his  present  holding,  having  a  fluctuating  and  uncer- 
tain dividend,  a  more  than  equal  amount  of  stock 
preferred  as  to  dividends,  and  in  addition  a  considerable 
amount  of  the  new  common  stock.  Very  few  stock- 
holders are  likely  to  refuse  so  attractive  an  oif er. 

The  application  of  these  principles  is  well  illustrated 
in  the  promotion  of  the  biggest  and  one  of  the  most 
successful  consolidations  that  has  yet  been  formed, 
the  United  States  Steel  Corporation.  So  important  is 
this  great  company,  not  only  in  connection  with  our 
present  study  of  corporation  finance,  but  in  its  influ- 
ence on  industry  in  this  country,  that  it  has  been  thought 
best  to  devote  a  separate  chapter  to  a  review  of  its  origin, 
its  promotion,  its  financial  history  and  its  prospects. 

104.  The  Interborough-Metropolitan  Consolidation, 
— Another  typical  consolidation  which  was  formed  under 
very  difl*erent  conditions  is  the  Interborough-Metropol- 
itan Company,  the  holding  company  for  the  transporta- 
tion companies  of  New  York  City.  A  chart  showing 
the  complicated  internal  organization  of  the  company 
has  been  presented  in  Chapter  VI.  The  terms  of  the 
consolidation  are  clearly  set  forth  in  the  following  ex- 
tract from  a  lecture  by  Albert  W.  Atwood,  Financial 
Editor  of  the  New  York  Press  and  Lecturer  on  Invest- 
ments in  New  York  University. 

1.  Companies  Taken  Over. 

Metropolitan  Street  Railway  $  52,000,000  stock 

Metropolitan  Securities  Co.  30,000,000      " 

Interborough  Rapid  Transit  Co.  35,000,000      " 

$117,000,000 


FORMING  CONSOLIDATIONS  197 

2.  Capitalization  of  Inter-Met. 

Bonds  $  70,000,000 

Preferred  Stock  55,000,000 

Common  Stock  100,000,000 


Total         $225,000,000 
Deduct  117,000,000 


Excess         $108,000,000 
3.  Basis  of  Exchange. 

Interborough  —  one  share  received  $200  bond  and  $99 
common  stock  in  the  Inter-Met. 

Metropolitan  Street  —  one  share  received  $100  pre- 
ferred and  $55  common  in  the  Inter-Met. 
Metropolitan  Securities  —  one  share,  $75  paid  up,  re- 
ceived $93.50  common  in  the  Inter-Met. 
The  Interborough-Metropolitan  took  over  practically  all  the 
capital  stock  of  the  subsidiary  companies.  In  1902  the  Metro- 
politan Street  Railway,  which  had  been  the  company  which  con- 
trolled and  operated  the  surface  lines,  ran  short  of  money  and  a 
scheme  was  devised  to  keep  it  going  by  leasing  it  to  the  New 
York  City  Railway  (which  had  a  comparatively  small  amount  of 
stock)  the  stock  of  which  was  in  turn  all  taken  over  by  the  Met- 
ropolitan Street  Railway  shareholders.  By  getting  a  large  ma- 
jority of  the  stocks  of  the  Metropolitan  Street  Railway  and  the 
Metropolitan  Securities  Company  the  Inter-Metropolitan  got 
control  of  the  entire  surface  system  and  by  securing  the  stock 
of  the  Interborough  Rapid  Transit  it  got  control  of  the  subway 
and  elevated  lines.  The  total  of  securities  taken  over  was  about 
$117,000,000  and  the  new  company  issued  $225,000,000  of 
securities.  The  excess  capitalization  was  $108,000,000,  which 
in  view  of  the  fact  that  many  believed  the  surface  lines  were 
already  waterlogged,  was  a  remarkable  piece  of  finance.  Three 
reasons  are  advanced  for  the  excess  capitalization : 

1.  The  promoters  say  they  honestly  believed  that  within  two 
or  three  years  the  common  stock  would  be  earning  2  per  cent. 

2.  The  merger  was  formed  at  the  height  of  the  business  and 


198  CORPORATION  FINANCE 

financial  boom  of  1906  and  at  that  time  the  present  financial  and 
business  reaction  was  not  generally  foreseen. 

3.  The  holders  of  the  securities  of  the  old  companies  had  to 
have  an  inducement  to  exchange  their  securities  for  the  new  ones. 
In  other  words,  they  had  to  be  hypnotized  into  believing  that 
they  were  getting  something  for  nothing.  Much  was  made  of 
the  growth  of  the  passenger  traffic  in  New  York  and  the  official 
prospectuses  declared  the  common  stock  of  the  new  combine 
would  certainly  be  able  to  pay  dividends  in  time  owing  to  the 
growth  of  population. 

These  two  illustrations  will  serve  to  indicate  the  gen- 
eral practice  in  exchanging  a  consolidated  company's 
securities  for  those  of  the  subsidiary  companies.  It 
may  be  observed  that  the  steel  consolidation  was  far 
more  conservative  than  was  the  Interborough-Metro- 
politan  consolidation.  The  second-named  company  was 
in  a  dangerous  situation  from  the  very  beginning, 
for  it  was  compelled  to  pay  regular  interest  on  its 
large  bond  issue  or  go  into  receivers'  hands.  The  steel 
corporation  gave  only  a  small  amount  of  bonds — rela- 
tive to  its  total  capitalization — and  consequently  was  not 
in  serious  danger  of  insolvency.  Even  if  it  had  failed 
to  pay  interest  on  its  preferred  stock  it  would  not  have 
been  forced  into  a  perilous  position.  The  Interborough- 
Metropolitan  financing  was  on  its  face  so  unsound  as  to 
arouse  the  suspicion  that  this  particular  consolidation 
was  never  intended  to  succeed. 


CHAPTER  XV 

THE  UNITED  STATES  STEEL  CORPORATION 

105.  Preparing  the  ground. — 1890  to  1900  is  an  im- 
portant decade  in  the  history  of  the  steel  business  of  the 
United  States.  Between  1890  and  1893  production  was 
vastly  increased,  while  the  demand  for  iron  and  steel 
products  practically  stood  still.  As  a  result,  prices 
were  declining  and  a  majority  of  the  steel  producers 
were  in  a  precarious  situation  even  before  the  severe  crisis 
of  1893  began  its  work  of  destruction.  The  crisis  hit  the 
steel  makers  especially  hard,  and  wiped  out  many  of  the 
small  concerns.  In  the  five  years  of  depression  that 
followed,  individuals  and  partnerships  as  factors  in  steel 
production  almost  disappeared;  their  places  were  taken 
by  comparatively  large  and  strong  corporations.  These 
corporations  not  only  managed  to  live,  but  even  to  thrive 
in  a  way,  because  they  were  able  to  buy  new  plants  and 
enlarge  old  ones  at  bargain  prices.  By  the  year  1898 
in  all  branches  of  the  steel  industry,  including  bar  iron, 
rolled  iron,  steel  rails,  sheet  steel,  tin  plate,  wire,  and 
other  more  highly  finished  products,  a  considerable 
number  of  fairly  efficient  and  well-managed  corpora- 
tions, which  had  grown  in  strength  during  the  depres- 
sion, were  prepared  to  handle  the  flood  of  new  business 
that  was  expected  to  come  with  the  revival  of  good  times. 

The  flood  came  and  with  it  such  a  rise  in  prices  and  a 
deluge  of  profits  as  would  have  seemed  inconceivable 
two  or  three  years  before.  Steel,  in  Andrew  Carnegie's 
picturesque  phrase,  is  either  "a  prince  or  a  pauper." 

199 


200  CORPORATION  FINANCE 

The  reason  is  that,  as  large  amounts  of  fixed  capital 
must  be  invested,  the  supply  of  steel  products  cannot 
easily  be  increased  or  decreased ;  whereas,  as  steel  is  not  a 
prime  necessity,  the  demand  fluctuates  violently.  In 
other  words,  since  supply  and  demand  do  not  move  up 
and  down  together,  prices  and  profits  jump  from  one 
extreme  to  the  other  with  extraordinary  rapidity. 

106.  The  steel  consolidations  preceding  the  forma- 
tion of  the  United  States  Steel  Corporation, — In  1898, 
then,  American  steel  makers  had  reached  a  higher  level 
of  prosperity  than  ever  before  and  were  moving  rapidly 
upward ;  the  business  was  carried  on  by  a  comparatively 
few  fairly  strong  corporations  in  each  line;  at  the  same 
time,  public  interest  in  the  advantages  of  industrial  com- 
binations and  in  their  supposed  opportunities  for  great 
profits  was  keen  and  the  public  appetite  for  the  securi- 
ties of  such  combinations,  or  "trusts,"  had  been  excited. 
Placing  these  three  factors  together,  we  see  why  the 
three  years  following,  1898-1901,  were  marked  by  a 
remarkable  series  of  steel  consolidations.  We  cannot 
take  time  here  to  tell  the  stories,  interesting  though  they 
would  be,  of  these  consolidations.  For  our  purpose  it 
will  be  enough  to  name  the  important  steel  companies  in 
existence  in  1900. 

1.  The  Federal  Steel  Company  was  formed  in  Sep- 
tember, 1898,  by  combining  the  Illinois  Steel  Company, 
the  Minnesota  Iron  Company,  and  the  Elgin,  Joliet  and 
Eastern  Railroad.  Its  authorized  capital  was  $200,- 
000,000,  of  which,  however,  only  $99,700,000  was  ever 
issued. 

2.  The  American  Steel  &  Wire  Company  was  organ- 
ized by  John  W.  Gates  in  March,  1898.  It  was  big 
enough  to  control  virtually  the  entire  production  of  wire 
goods.     Its  capital  was  $90,000,000. 


THE  UNITED  STATES  STEEL  CORPORATION      201 

3.  The  National  Tube  Company,  formed  in  Feb- 
ruary, 1899,  included  over  a  dozen  companies.  It  was 
the  largest  concern  of  its  kind  in  the  world  and  at  the 
time  the  third  largest  concern  in  the  iron  and  steel  busi- 
ness, being  surpassed  only  by  Carnegie  and  Krupps,  of 
Germany. 

4.  The  National  Steel  Company,  the  American  Steel 
Hoop  Company,  the  American  Sheet  Steel  Company 
and  the  American  Tin  Plate  Company  were  organized 
in  the  period  from  December,  1898,  to  March,  1900,  by 
Judge  W.  H.  Moore,  his  brother,  James  H.  Moore, 
Daniel  G.  Reid,  William  B.  Leeds,  and  others  who  have 
come  to  be  known  as  the  "Moore  Party"  or  "Rock  Island 
Crowd."  Of  these  concerns  the  largest  was  the  Tin 
Plate  Company,  which  was  a  consolidation  of  forty  com- 
panies, embracing  about  95  per  cent  of  the  total  output 
of  tin  plate  in  the  United  States. 

5.  The  biggest  and  most  powerful  company  of  all. 
The  Carnegie  Company,  was  not  a  consolidation,  but  a 
growth.  This  great  concern  had  been  built  up  by  the 
consistent  policy,  extending  over  many  years,  of  putting 
most  of  its  earnings  into  improvements  instead  of  into 
dividends.  The  organizing  genius  of  Carnegie,  Frick, 
Phipps,  and  their  coworkers,  had  made  its  body  of  work- 
ingmen  the  most  efficient  and  its  enormous  plant  the 
most  economical  in  the  world.  Through  its  control  of 
the  H.  C.  Frick  Coke  Company,  the  Oliver  Mining 
Company,  the  Pittsburg  Steamship  Company  and  the 
Pittsburg,  Bessemer  &  Lake  Erie  Railroad,  together 
with  its  fifty-year  contract  with  the  Rockefeller  iron, 
mining  and  transportation  companies,  its  supply  of  raw 
materials  at  low  cost  was  assured  for  many  years  to 
come. 

107.  A  condition  of  unstable  equilibrium, — In  one  of 


20«  CORPORATION  FINANCE 

the  most  brilliant  chapters  in  his  well-known  volume  on 
"Trust  Finance"  Professor  E.  S.  Meade  has  well  de- 
scribed the  conditions  in  the  steel  business  in  1900.  In- 
dustrially the  situation  might  be  said  to  be  one  of  un- 
stable equilibrium.  It  might  have  been  expected  that 
all  of  these  consolidations  would  have  been  content  to 
enjoy  the  prosperity,  which  was  being  showered  upon 
steel  makers,  and  would  have  desisted  from  intense  com- 
petition with  each  other.  Ordinarily  competitive  strife 
awakens  in  periods  when  business  is  stagnant  and  mills 
idle,  while  harmony  is  readily  secured  so  long  as  orders 
are  outrunning  production.  This  would,  in  fact,  have 
been  the  happy  situation  in  the  steel  trade  if  it  had  not 
been  for  the  appearance  of  a  powerful  new  factor,  the 
tendency  toward  integration.  "Integration"  is  the 
economists'  technical  word  for  the  control  by  one  concern 
of  the  whole  process  of  production  from  the  raw  material 
to  the  finished  product.  Ordinarily  the  manufacture  of 
iany  finished  article,  say  a  tin  can,  is  carried  on  through 
several  stages,  and  at  each  stage  passes  from  one  group 
of  producers  to  another  group.  In  making  the  tin  can 
iron  ore  must  be  mined ;  the  miner  sells  his  ore  to  a  manu- 
facturer who  transforms  it  first  into  iron  and  next  into 
steel;  this  manufacturer  sells  his  product  to  a  manufac- 
turer of  sheet  steel,  who  in  turn  passes  it  on  to  the  manu- 
facturer of  tin  plate ;  finally  the  can  manufacturer  buys 
the  tin  plate  and  forms  it  into  tin  cans.  At  each  stage 
of  such  a  process  there  is  a  sale  of  the  partly  finished 
product  and  a  profit  is  taken  that  enters  into  the  final 
cost  of  production.  Under  the  policy  of  integration, 
according  to  which  all  these  stages  are  combined  under 
the  control  of  one  great  manufacturing  concern,  a  two- 
fold advantage  is  gained;  first,  the  intermediate  profits 
are  all  secured ;  second,  a  permanent,  dependable  supply 


THE  UNITED  STATES  STEEL  CORPORATION 

of  raw  materials  at  lowest  costs  is  assured.  This  second 
advantage  is  even  more  important  than  the  one  first 
named. 

The  Carnegie  Company  in  1900  up  to  a  certain  point 
was  an  integrated  company;  that  is,  it  controlled  great 
quantities  of  ore  and  coal,  owned  its  own  steamships  and 
railroads  for  the  transportation  of  these  raw  materials 
to  its  Pittsburg  plants,  and  at  the  Pittsburg  plants 
turned  out  steel  rails  and  a  large  variety  of  half -finished 
products.  It  was  partly  for  this  reason  that  the  com- 
pany had  become  so  strong  and  prosperous.  Neverthe- 
less, it  was  by  no  means  wholly  independent,  for  its  chief 
customers  were  the  other  steel  companies  in  the  Pitts- 
burg district  which  purchased  its  steel  billets,  ingots, 
bars,  plates  and  slabs.  The  Federal  Steel  Company, 
also,  was  "integrated"  up  to  a  certain  point,  but  like  the 
Carnegie  Steel  Company  was  by  no  means  independent 
of  its  large  customers.  A  large  part  of  its  business 
consisted  in  furnishing  wire  rods  to  the  American  Steel 
and  Wire  Company  and  steel  billets  to  the  National 
Tube  and  the  American  Bridge  Companies.  The  Na- 
tional Steel  Company,  a  much  smaller  concern,  furnished 
part-finished  products  to  the  other  Moore  companies,  the 
American  Tin  Plate,  American  Sheet  Steel,  and  Ameri- 
can Steel  Hoop. 

The  group  of  producers  of  finished  steel  products 
were  by  no  means  satisfied  with  their  position.  They 
desired  to  secure  the  advantages  of  integration  for  them- 
selves ;  particularly  they  were  anxious  to  free  themselves 
from  the  domination  of  the  concerns  on  which  they  were 
dependent  for  raw  materials.  Therefore,  all  of  these 
companies  in  1898, 1899  and  1900  were  planning  to  pur- 
chase ore  and  coal  lands,  to  get  control  of  transportation 
companies  and  to  construct  furnaces  and  mills  for  the 


^04  CORPORATION  FINANCE 

manufacture  of  part-finished  steel  products.  The 
American  Steel  and  Wire  Company  bought  two  thou- 
sand acres  of  Connellsville  coal  land  and  large  ore  prop- 
erties. It  already  had  partially  under  its  control  a  fleet 
of  twelve  ore  steamers.  It  now  announced  its  intention 
to  build  large  steel  plants  at  Milwaukee  and  Pittsburg. 
The  National  Steel  Company  purchased  iron  mines  and 
coal  land  and  started  to  increase  its  furnace  capacity. 
The  National  Tube  Company  began  work  on  a  large 
steel  plant  at  Wheeling,  West  Virginia. 

The  completion  of  these  projects  meant  heavy  loss  to 
the  Carnegie  Company  and  the  Federal  Steel  Company. 
They  were  forced  to  fight  back.  The  Federal  Steel 
Company  threatened  to  build  wire  mills  unless  the 
American  Steel  and  Wire  Company  should  abandon  its 
proposed  Milwaukee  plant,  and  the  threat  for  the  time 
being  proved  effective.  The  Carnegie  Company  an- 
nounced that  it  would  construct  a  large  tube  mill  at 
Conneaut,  Ohio,  and  let  it  be  understood  that  it  would 
not  hesitate  to  enter  into  active  competition  with  all  the 
producers  of  finished  goods.  There  was  no  doubt  in 
the  minds  of  those  who  knew  Andrew  Carnegie  but  that 
these  plans  would  actually  be  carried  out.  They  recalled 
that  "the  wild  Scotchman"  had  been  successful  in  even 
more  daring  schemes. 

The  situation  was  full  of  dangers.  The  prosperity 
of  the  steel  makers  could  not  continue  through  the  bitter 
competitive  war  that  seemed  to  be  in  prospect.  The 
officials  of  the  Carnegie  Company  apparently  were  not 
seriously  worried,  for  they  felt  confident  of  the  ability 
of  their  organization  to  finance  and  make  highly  profit- 
able in  the  end  whatever  new  construction  might  become 
necessary.  The  officials  of  the  other  great  companies, 
however,  were  not  so  complacent.     All  of  the  large  con- 


THE  UNITED  STATES  STEEL  CORPORATION      205 

solidations  were  capitalized,  as  we  shall  see,  up  to  the 
limit  of  their  earning  power,  and  their  stock  had  been 
sold  on  the  promise  of  large  and  regular  dividends. 
Moreover,  large  amounts  of  the  stock  were  still  owned 
by  the  original  promoters  and  underwriters.  The  man- 
agers, therefore,  were  far  from  eager  to  enter  into  a 
regime  of  severe  competition.  Under  these  conditions 
the  suggestion  that  an  immense  holding  company,  the 
greatest  trust  in  the  world,  be  formed  was  favorably 
received.  It  furnished  the  only  possible  peaceful  so- 
lution of  the  pending  problems.  The  strongest  finan- 
cial houses,  as  well  as  the  largest  steel  companies,  were 
committed  in  advance  to  this  plan,  because  it  was  the 
only  means  of  protecting  them  from  severe  loss. 

108.  Method  of  promotion. — The  promotion  of  the 
United  States  Steel  Corporation  was  not,  for  the  reasons 
that  have  been  given,  an  especially  difficult  task.  The 
chief  obstacle  was  overcome  when  men  of  sufficient 
breadth,  imagination  and  ability  to  form  a  clear  con- 
ception of  what  was  to  be  done  had  been  found.  So 
stupendous  an  undertaking  could  only  be  carried  out 
by  the  giants  of  the  financial,  the  industrial  and  the 
legal  worlds.  Fortunately  for  the  project,  the  right 
men  were  at  hand  and  were  interested  in  its  success; 
above  all,  the  active  support  of  Mr.  J.  P.  Morgan,  the 
most  forceful  personality  in  Wall  Street,  did  more  than 
anything  else  to  make  the  plan  practicable  and  ultimately 
successful. 

The  details  of  the  promotion  of  the  United  States 
Steel  Corporation  have  never  been  disclosed.  Long  in- 
vestigation was  not  as  necessary  as  in  most  promotions 
for  the  reason  that  the  promoters  were  familiar  at  first 
hand  with  the  concerns  to  be  consolidated.  The  plan 
at  first,  it  is  known,  was  to  combine  only  the  great  com- 


206  CORPORATION  FINANCE 

panics;  the  Carnegie  Steel  Company,  Federal  Steel 
Company,  National  Tube  Company  and  the  American 
Steel  and  Wire  Company.  The  potential  competition, 
however,  of  the  four  Moore  companies  looked  so  threat- 
ening that  they  also  were  brought  into  the  combination. 
Certain  other  large  companies,  such  as  the  Jones  and 
Laughlin  Steel  Company,  of  Pittsburg,  were  ap- 
proached, but  no  terms  were  agreed  upon. 

The  United  States  Steel  Corporation  filed  its  certifi- 
cate of  incorporation  in  New  Jersey  on  February  23, 
1901,  showing  a  capitalization  of  $3,000.  Under  its 
amended  certificate  of  April  1,  1901,  however,  its  capi- 
talization was  changed  to  $1,100,000,000,  one-half 
common  and  one-half  preferred.  The  charter,  it  may  be 
noted,  gives  discretion  to  the  board  of  directors  to  in- 
crease its  capital  stock. 

109.  Prospectus  of  the  corporation, — In  the  light  of 
the  later  history  of  the  company  and  as  an  example  of 
scientific  prospectus-making,  some  extracts  from  the 
prospectus  issued  by  the  firm  of  J.  P.  Morgan  and 
Company  are  given  below.  The  reader  should  note 
how  carefully  each  positive  statement  is  qualified  and 
how  much  more  is  implied  as  to  prospective  profits  than 
is  actually  said.  Yet  the  prospectus  cannot  be  called 
misleading.  If  it  is  read  as  carefully  as  it  was  written,  it 
will  be  found  not  only  to  contain  technically  accurate 
statements,  but  to  give  a  correct  impression  as  well. 
The  difficulty  comes  in  the  fact  that  comparatively  few 
persons  are  capable  of  giving  it  a  careful  reading.  The 
prospectus  also  contains  a  sufficient  account  for  our  pur- 
pose of  the  basis  of  consolidation. 

A  syndicate,  comprising  leading  financial  interests  through- 
out the  United  States  and  Europe,  of  which  the  undersigned  are 


THE  UNITED  STATES  STEEL  CORPORATION     207 

managers,  has  been  formed  by  subscribers  to  the  amount  of 
$200,000,000  (including  among  such  subscribers  the  under- 
signed and  many  large  stockholders  of  the  several  companies), 
to  carry  out  the  arrangement  hereinafter  stated,  and  to  provide 
the  sum  in  cash  and  the  financial  support  required  for  that  pur- 
pose. Such  syndicate,  through  the  undersigned,  has  made  a 
contract  with  the  United  States  Steel  Corporation  under  which 
the  latter  is  to  issue  and  deliver  its  preferred  stock,  and  its 
common  stock,  and  its  5  per  cent  gold  bonds  in  consideration 
for  stocks  of  the  above-named  companies  and  bonds  and  stock 
of  the  Carnegie  Company  and  the  sum  of  $25,000,000  in  cash. 

The  syndicate  has  already  arranged  for  the  acquisition  of 
substantially  all  the  bonds  and  stock  of  the  Carnegie  Company, 
including  Mr.  Carnegie's  holdings.  The  bonds  of  the  United 
States  Steel  Corporation  are  to  be  used  only  to  acquire  bonds 
and  60  per  cent  of  the  stock  of  the  Carnegie  Company. 

The  syndicate  offers  for  each  $100  par  value  of  stock  of  the 
class  mentioned  below,  the  amount  set  opposite  thereto  in  pre- 
ferred stock  or  common  stock  of  the  United  States  Steel  Cor- 
poration at  par: 

Amount  op  new  stock  to 
be    delivered    in    par 
Name  of  company  and  value. 

class  of  stock.  r  ~ 

Preferred  Common 

Stock  Stock 

Federal  Steel  Company : 

Preferred  stock   ,.  ., >.  .   $110.00 

Common  stock  4.00        $107.50 

American    Steel   and   Wire   Company   of 
New  Jersey: 

Preferred  stock , ,.  .      117.50  .  .. 

Common  stock .,  102.50 

National  Tube  Company : 

Preferred   stock    125.00  

Common  stock 8.80  125.00 


208  CORPORATION  FINANCE 

National  Steel  Company: 

Preferred   stock , 1S5.00  

Common  stock  . ...,...., 125.00 

American  Tin  Plate  Company: 

Preferred   stock 125.00  

Common  stock ,       20.00  125.00 

American  Steel  Hoop  Company: 

Preferred  stock  . 100.00  

Common  stock ......  100.00 

American  Sheet  Steel  Company : 

Preferred  stock  .  ., 100.00  

Common  stock ,.  .  100.00 

With  reference  to  the  last  four  companies,  the  aggregate 
amount  of  stocks  so  to  be  offered  was  arranged  with  the  princi- 
pal stockholders  of  those  companies,  who  have  requested  the  dis- 
tribution of  such  amount  among  the  four  companies,  to  be 
made  in  the  percentages  above  stated. 

Statements  furnished  to  us  by  officers  of  the  several  companies 
above  named  and  of  the  Carnegie  Company  show  that  the  aggre- 
gate of  the  net  earnings  of  all  the  companies  for  the  calendar 
year  1900  was  amply  sufficient  to  pay  dividends  on  both  classes 
of  the  new  stocks,  besides  making  provisions  for  sinking  funds 
and  maintenance  of  properties.  It  is  expected  that  by  the  con- 
summation of  the  proposed  arrangement  the  necessity  of  large 
deductions  heretofore  made  on  account  of  expenditures  for  im- 
provements will  be  avoided,  the  amount  of  earnings  applicable 
to  dividends  will  be  substantially  increased,  and  greater  stability 
of  investment  will  be  assured,  without  necessarily  increasing  the 
prices  of  manufactured  products. 

All  shares  of  the  United  States  Steel  Corporation  deliverable 
to  or  for  account  of  the  syndicate,  which  shall  not  be  required 
for  the  acquisition  of  the  stock  of  the  Carnegie  Company  or  for 
delivery  to  depositors  under  terms  of  this  circular,  are  to  be 
retained  by  and  to  belong  to  the  syndicate. 

It  is  proper  to  state  that  J.  P.  Morgan  &  Co.  are  to  receive 
no  compensation  for  their  services  as  syndicate  managers  be- 


THE  UNITED  STATES  STEEL  CORPORATION     209 

yond  a  share  in  any  sum  which  ultimately  may  be  realized  by 
the  syndicate. 

J.  P.  Morgan  &  Co., 
Syndicate  Managers. 

110.  Profits  of  the  'promoters, — The  sum  which  ulti- 
mately was  realized  by  the  syndicate  was  never  made 
public,  but  it  is  easy  to  figure  that  it  must  have  been  in 
neighborhood  of  $240,000,000,  face  value,  of  common 
stock,  against  which  should  be  off-set  $25,000,000  cash 
furnished  by  the  syndicate  and  the  expenses  of  promo- 
tion. Assuming  that  the  common  stock  was  sold  by  the 
syndicate  members  at  an  average  price  of  thirty,  which 
is  probably  lower  than  the  actual  average,  we  have  gross 
profits  of  $72,000,000.  Deducting  the  $25,000,000  and 
assuming  expenses  to  have  been  $1,000,000,  we  have  left 
net  promoters'  and  underwriters'  profits  of  $46,000,000 
— a  huge  sum  and  yet  not  too  great,  considering  the 
risk  and  the  financial  power  and  ability  required  in  the 
unprecedented  undertaking. 

The  provision  of  cash  by  the  syndicate  was  a  somewhat 
unusual  method  of  meeting  this  part  of  the  financial 
problem  involved  in  promoting  a  consolidation. 

111.  Capitalization  at  the  he  ginning, — It  is  worth 
noting  that  the  $160,000,000  Carnegie  stock  obtained 
in  exchange  $98,000,000  preferred  stock,  $90,000,000 
common  stock  and  $144,000,000  bonds  of  the  Steel  Cor- 
poration. In  addition  $160,000,000  Carnegie  bonds  ob- 
tained an  equal  amount  of  United  States  Steel  collateral 
bonds.  Thus  the  par  value  of  the  stocks  and  bonds 
given  to  Carnegie  Company  security  holders  was  nearly 
one-half  billion '  dollars,  more  than  one-third  the  total 
capitalization  of  the  corporation.  The  aggregate  capi- 
talization of  the  other  seven  original  companies  was 
$457,000,000  and  the  par  value  of  Steel  stock  given  in 

1—14 


^10  CORPORATION  FINANCE 

exchange  was  $532,000,000,  an  increase  of  $75,000,000. 
The  terms  of  exchange  were  so  liberal  that  98  per  cent 
of  the  stock  of  the  original  eight  companies  was  acquired. 
Shortly  afterwards  two  other  companies  were  taken 
in,  namely: 

1.  The  American  Bridge  Company  which  had  been 
formed  in  April,  1900.  This  company  had  absorbed 
twenty-six  separate  concerns  and  embraced  over  nine- 
tenths  of  the  bridge-building  interests  of  the  United 
States. 

2.  The  Lake  Superior  Consolidated  Iron  Mines  Com- 
pany, which  owned  and  operated  valuable  mines  in  the 
Mesaba  range  of  the  Lake  Superior  iron  region. 

Practically  all  the  securities  of  the  Lake  Superior 
Company  were  acquired  and  85  per  cent  of  the  stock  of 
the  American  Bridge  Company. 

The  capitalization  of  the  United  States  Steel  Corpo- 
ration at  the  end  of  the  first  year  was  as  follows : 

Capital  Stock,  Preferred .   $  510,281,100.00 

"           "        Common    508,302,500.00 

Capital  Stock  of  Subsidiary  Cos.,  outstand- 
ing   . 215,914.38 

U.  S.  Steel  Bonds  . 303,757,000.00 

Other  bonds - 56,997,326.00 


$1,379,553,840.38 


The  figures  following  will  give  some  idea  of  the 
enormous  extent  of  the  steel  corporation's  property  at 
the  beginning:  213  diff*erent  plants  and  transportation 
companies;  41  mines;  nearly  1,000  miles  of  railroad;  a 
lake  fleet  of  112  vessels  which  constituted  one-third  total 
tonnage  of  Northern  Lakes;  controlled  78  blast  fur- 
naces, one-third  of  the  number  in  United  States;  owned 


I 


i 


THE  UNITED  STATES  STEEL  CORPORATION      ^11 

57,000  acres  of  coking  coal  land;  leased  50,000  acres 
Pocahontas  Coal  land,  W.  Va.;  owned  considerable 
areas  of  steam  and  gas  coal  in  Illinois.  The  most  im- 
portant assets  of  all  were  the  ore  deposits  in  the  Lake 
Superior  region,  which  were  estimated  by  Mr.  Schwab 
at  750,000,000  tons. 

112.  Additions, — The  principal  additions  to  the  steel 
corporation  have  been: 

1— Shelby  Tube  Co.   . .- 1901 

2— Union  Steel  Co.  1902 

S — Holdings  of  Chemung  Iron  Co.,  Duluth.  .i 1903 

4— Properties  of  Clairton  Steel  Co 1904. 

5 — Lease  of  Hill  holdings  in  Lake  Superior  Region  ....  1906 
6 — Tennessee  Coal,  Iron  and  Railroad  Company 1907 

The  Shelby  Steel  Tube  Company  was  a  small  and 
greatly  over-capitalized  concern  which  was,  however,  the 
largest  maker  of  seamless  tubing  in  the  world. 

The  Union  Steel  Company  was  a  consolidation  of 
seven  coke-mining,  sheet  steel,  tin  plate  and  steel  com- 
panies in  and  near  Sharon,  Penna. 

The  Chemung  Iron  Company  was  a  Detroit  concern 

hich  owned  a  large  and  important  block  of  Mesaba 
re  deposits. 

The  Clairton  Steel  Company  was  a  Pittsburg  concern 
which  owned  a  large  plant,  2,600  acres  of  coking  coal 
land,  20,000  acres  of  mineral  lands  in  the  Marquette 
Range  and  considerable  railroad  and  limestone  proper- 
ties. 

On  April  15,  1907,  the  notable  lease  of  the  Hill  ore 
lands  was  ratified.  The  lease  provides  that  a  royalty  of 
$1.65  per  gross  ton  for  ore  of  a  fixed  grade  was  to  be 
paid  in  1907  and  the  royalty  increased  3  4-10  cents  per 
ton  each  succeeding  year.     The  minimum  to  be  mined 


212  CORPORATION  FINANCE 

and  shipped  was  750,000  tons  in  1907  and  is  to  increase 
750,000  tons  per  year  until  it  reaches  8,250,000  tons. 
The  lease  will  continue  until  the  ore  is  exhausted,  the 
option  being  reserved,  however,  to  the  steel  corporation 
to  determine  the  lease  in  1915. 

In  November,  1907,  the  corporation  acquired  about 
$30,000,000,  or  practically  all,  of  the  outstanding  com- 
mon stock  of  the  Tennessee  Coal,  Iron  and  Railroad 
Company.  The  stock  was  paid  for  at  the  rate  of  $11,- 
904.76  par  value  of  the  10-60  year  sinking  fund  5  per 
cent  bonds  of  the  steel  corporation  for  $10,000  par  of 
Tennessee  common.  Most  readers  no  doubt  will  recall 
the  circumstances  surrounding  this  deal.  It  was  made 
possible  by  the  ability  of  the  steel  corporation  to  put 
up  ready  cash  in  the  critical  time  of  the  October,  1907, 
crisis.  The  cash  was  used  to  buy  in  the  steel  corpora- 
tion's own  bonds  with  which  to  pay  for  Tennessee  stock. 
The  operation  thus  had  a  double  effect  of  supplying 
cash  to  persons  who  needed  it  badly,  and  of  supplying 
a  security,  which  was  acceptable  as  collateral,  in  place 
of  the  unavailable  Tennessee  stock.  The  Tennessee 
Company  owned  16  blast  furnaces,  450,000  acres  of 
coal,  ore  and  limestone  and  timber  lands,  large  developed 
coal  mines  and  a  big  steel  rail  mill  at  Ensley,  Ala. 

Besides  these  large  purchases  the  steel  corporation 
has  also  increased  its  holdings  by  building  out  of  its 
earnings  an  entirely  new  plant.  At  Gary,  Indiana, 
there  has  been  erected  a  large  modern  steel  rail  mill  at 
a  cost  of  $75,000,000.  The  mill  began  operations  in 
1908.  At  Duluth,  Minn.,  1,350  acres  of  ground  have 
been  purchased  and  arrangements  have  been  partially 
made  to  put  up  another  large  steel  mill.  Both  these 
new  plants  are  called  for  by  the  great  increase  in  the 
western  demand  for  steel. 


THE  UNITED  STATES  STEEL  CORPORATION     213 

113.  Fina7icial  changes, — The  chief  event  in  the 
financial  history  of  the  steel  corporation  is  its  much 
discussed  preferred  stock  conversion  of  1902.  In  April 
of  that  year  the  management  issued  a  circular  to  stock- 
holders saying  that  $50,000,000  new  capital  was  needed, 
one-half  for  redemption  of  temporary  loans  incurred  by 
constituent  companies  and  one-half  for  improvements. 
The  plan  proposed  was  to  create  a  new  issue  of  $250,- 
000,000  5  per  cent  bonds,  of  which  $200,000,000  was  to 
be  exchanged,  dollar  for  dollar,  for  an  equal  amount  of 
preferred  stock  and  $50,000,000  was  to  be  sold  for  cash. 
Each  preferred  stockholder  was  offered  the  right  to  sub- 
scribe to  the  extent  of  one-half  his  holdings,  paying  40 
per  cent  in  stock  and  10  per  cent  in  cash,  or  to  the  extent 
of  40  per  cent  of  his  holdings,  paying  in  stock  alone. 
The  argument  urged  for  this  plan  was  that  the  $50,000,- 
000  would  be  raised  and  yet  an  annual  saving  in  the 
company's  charges  of  $1,500,000  would  be  eiFected. 
To  this  plan  99  8-10  per  cent  of  the  stock  voted  at  the 
annual  meeting  assented. 

The  plan  was  objectionable,  however,  to  certain  stock- 
holders for  the  obvious  reason  that  a  new  issue  was  cre- 
ated superior  to  their  own  security  without  any  corre- 
sponding enhancement  in  the  value  of  the  corporation's 
assets.  The  plan  was  further  objectionable  in  that  the 
issue  was  to  be  underwritten  by  a  syndicate  which  in- 
cluded some  of  the  corporation's  directors.  The  syndi- 
cate agreed  to  take  enough  of  the  bonds  to  bring  the 
total  sale  up  to  $100,000,000.^  In  return  they  were  to 
have  the  privilege  of  subscribing  to  any  or  all  of  the 
bonds  not  taken  by  the  stockholders  and  they  were  to  get 
a  4  per  cent  commission  on  all  the  bonds  sold  to  the  stock- 
holders or  otherwise.     It  was  objected  that  under  this 

1  See  a  copy  of  the  agreement  in  Chapter  XIX. 


^14  CORPORATION  FINANCE 

agreement  the  syndicate  took  a  very  slight  risk  inasmuch 
as  it  was  practically  certain  that  at  least  $100,000,000 
worth  of  bonds  would  be  sold,  and  got  an  excessive  com- 
mission. The  objections  on  this  score  were  never  satis- 
factorily answered. 

The  opponents  of  the  conversion  plan  secured  a  tem- 
porary injunction  and  brought  suit  to  restrain  the  di- 
rectors from  carrying  out  the  plan.  The  decisions  of 
the  court,  however,  were  in  favor  of  the  steel  corpora- 
tion management,  on  the  ground  that  no  fraud  was 
shown  and  that  the  great  majority  of  the  stockholders 
had  approved  the  issue.  The  danger  of  disaster  to  the 
corporation,  on  account  of  its  great  increase  in  bonded 
obligations,  is  somewhat  lessened  by  the  fact  that  the 
interest  on  these  sinking  fund  5's  must  lapse  for  two 
years  before  foreclosure  proceedings  can  be  commenced. 
This  provision  is  a  safeguard  to  the  corporation,  though, 
of  course,  it  would  not  be  of  great  value  in  a  period  of 
prolonged  depression  like  that  from  1893  to  1897. 

The  slump  in  the  steel  business  in  1903  made  it  neces- 
sary for  the  corporation  to  economize.  Several  mills 
were  dismantled  and  some  of  the  sub-executive  offices 
were  abolished.  It  became  desirable  to  change  somewhat 
the  financial  organization  of  the  corporation.  In  March, 
1903,  the  original  Carnegie  Company  of  Pennsylvania, 
the  National  Steel  Company  and  the  American  Steel 
Hoop  Company  were  combined  under  the  name  of  the 
Carnegie  Steel  Company  of  New  Jersey  and  later  in 
the  year  the  American  Sheet  Steel  Company  and  the 
American  Tin  Plate  Company  were  combined  as  the 
American  Sheet  and  Tin  Plate  Company.  Early 
the  next  year  the  corporation's  search  for  wider  markets 
led  to  the  formation  of  the  United  States  Steel  Products 
Export  Company,  which  is  the  selling  agency  for  all 


THE  UNITED  STATES  STEEL  CORPORATION     215 

the  foreign  business  of  the  corporation.     The  direct  con- 
trol of  this  company  is  in  the  Federal  Steel  Company. 

114.  Basis  of  capitalization, — Is  the  steel  corpora- 
tion over-capitalized?  It  is  not  worth  while  to  rehash 
the  wordy  debate  on  this  question,  which  has  lasted  for 
several  years,  but  a  few  facts  ought  to  be  noted.  The 
aggregate  capitalization  of  the  first  ten  companies  to 
enter  the  corporation  was  approximately  $710,000,000. 
In  exchange  for  this  amount  of  stock  the  corporation 
issued  $868,000,000  stock  and  $144,000,000  bonds,  an 
increase  of  $302,000,000.  In  addition  the  promoters  of 
the  steel  corporation  received  for  their  services  some- 
thing over  $240,000,000  in  stock.  Even  though  we 
should  estimate  that  all  the  subsidiary  companies'  stock 
represented  tangible  assets,  therefore,  we  should  still 
have  to  conclude  that  $542,000,000  of  United  States 
Steel  capitalization  was  water  at  the  start. 

But  what  are  the  facts  as  to  the  capitalization  of  the 
original  companies?  Daniel  G.  Reid,  president  of  the 
American  Tin  Plate  Company,  testified  before  the  In- 
dustrial Commission  that  of  the  $46,000,000  capitaliza- 
tion of  that  company,  $18,000,000  (preferred  stock) 
was  supposed  to  represent  the  value  of  the  property  and 
$28,000,000  (common  stock)  represented  hopes  for  the 
future  and  the  pay  of  the  promoter.  It  is  well  known 
that  in  the  capitalization  of  the  National  Steel,  Ameri- 
can Steel  Hoop  and  American  Steel  Sheet  companies, 
all  of  which  were  promoted  by  the  same  interests  as  the 
American  Tin  Plate  Company,  the  same  principle  was 
followed. 

Similarly,  Mr.  John  W.  Gates  testified  that  of  the 
$80,000,000  capitalization  of  the  American  Steel  and 
Wire  Company,  $20,000,000  to  $30,000,000  was  water. 
Of  the  $100,000,000  capitalization  of  the  Federal  Steel 


ne  CORPORATION  FINANCE 

Company,  about  $45,000,000  represented  tangible  assets 
and  $10,000,000  cash  assets,  while  the  rest  was  water. 
These  statements  are  enough  to  indicate  that  of  the 
$710,000,000  capitalization  of  the  original  companies,  a 
large  share  stood  for  nothing  more  tangible  than  good 
will  and  "prospects." 

The  suits  to  prevent  the  carrying  out  of  the  preferred 
stock  conversion  plan  of  1903  brought  out  some  inter- 
esting statements.  One  affidavit,  by  an  engineer  who 
was  represented  as  an  expert,  said  that  the  plants  and 
properties  of  the  corporation  could  be  duplicated  for 
about  $200,000,000  and  that  the  total  assets,  including 
good  will  and  organization,  were  not  worth  $500,000,- 
000,  Another  affidavit  stated  that  the  plants  of  the 
Carnegie  Company,  represented  44  per  cent  of  the  pro- 
ductive capacity  of  the  steel  corporation  and  that  these 
plants  had  been  valued  on  March  12,  1900,  by  the  part- 
ners of  the  Carnegie  Company  in  a  legal  proceeding  at 
$75,000,000.  On  the  other  hand,  Mr.  Charles  M. 
Schwab,  then  president  of  the  steel  corporation,  sub- 
mitted the  following  valuation: 

1— Iron-ore  Properties ., $    700,000,000 

2— Plants,  Mills,  Fixtures,  Equipments   300,000,000 

3— Coal  and  coke  fields,  87,589  acres 100,000,000 

4 — Transportation  properties 80,000,000 

5— Blast  Furnaces ,.  .  .  48,000,000 

6— Natural  Gas  Fields 20,000,000 

7— Lime  Stone  Properties   . 4,000,000 

8— Cash  and  cash  assets , 214,278,000 


I 


$1,466,278,000 


There  is  not  such  a  great  difference  between  these 
two  estimates  as  at  first  appears.  More  than  one-half 
the  assets,  as  given  by  Mr.  Schwab,  consist  of  ore  and 


THE  UNITED  STATES  STEEL  CORPORATION;      217 

coal  land  in  which  he  included  unmined  ore  at  a  high 
value.  Beyond  question,  such  an  estimate  is  uncertain 
and  speculative.  Technical  progress  may  introduce  new 
methods  of  treating  ore  which  will  greatly  reduce  the 
value  of  this  large  buried  mass.  Besides,  Mr.  Schwab 
had  already  counted  the  value  of  this  ore  once  when  he 
based  his  estimate  of  the  value  of  the  plants  on  their 
low  cost  of  production  and,  as  a  factor  in  that  low  cost, 
counted  in  the  cheapness  with  which  they  could  secure 
raw  materials. 

In  what  has  been  said  it  has  been  assumed  that  the 
proper  way  to  value  a  property  is  to  arrive  at  the  prob- 
able cost  of  replacing  it.  But  there  is  another  method 
of  valuation  which  is  more  popular  among  business  men, 
and,  to  the  writer's  mind,  more  scientific.  This  method 
is  to  capitalize  earning  power.  The  profits  of  the  eight 
original  sub-companies  of  the  steel  corporation  in  1900 
were  $96,000,000.  The  record  of  the  Steel  Corporation 
in  the  first  seven  years  of  its  history  was  as  follows: 

Net  Earnings 

1902 , $133,308,000 

1903    109,171,000 

1904 73,176,000 

1905 119,787,000 

1906 156,624,000 

1907 160,965,000 

1908 , , 91,267,000 

Average .  ., .   $120,614,000 

Now  if  we  assume  that  10  per  cent  is  a  fair  rate  on 
money  invested  in  the  steel  business  and  capitalize  prof- 
its on  that  basis,  we  get  a  result  not  a  great  deal  below  the 
present  capitalization. 


218  CORPORATION  FINANCE 

Our  general  conclusion  on  this  point  must  be  some- 
thing like  this:  If  the  properties  of  the  steel  corpo- 
ration were  sold  under  the  hammer,  they  probably  would 
not  fetch  one-half  or  one-third  the  amount  at  which  the 
corporation  is  capitalized.  Even  if  we  take  into  con- 
sideration good  will,  organization,  financial  connections, 
and  so  on,  we  could  hardly  say  that  the  assets  equal  or 
nearly  equal  the  capitalization.  But,  if  we  base  our 
valuation  on  earnings,  not  assets,  we  can  safely  say  that 
the  over-capitalization  is  not  very  great. 

The  steel  corporation  is  earning  immense  sums  be- 
cause it  is  well  managed ;  because  it  has  prestige ;  because 
in  some  lines  it  has  almost  a  complete  monoply.  These 
things  are  not  tangible  assets,  but  they  are  sources  of 
income;  and  income,  according  to  ordinary  business  us- 
age may  properly  be  capitalized. 

Even  from  the  ultra-conservative  standpoint,  it  may 
be  said  that  the  steel  corporation  is  rapidly  "squeezing 
out  the  water"  for  it  has  made  it  its  policy  to  provide 
from  its  gross  income  for  depreciation  and  for  improve- 
ments. The  figures  following  show  that  about  $300,- 
000,000  have  thus  been  added  to  the  tangible  assets  of 
the  corporation  since  its  formation. 

Sinking  Funds,  subsidiary  companies $     9,367,412 

Sinking  Funds,  U.  S.  Steel  Bonds 25,624,410 

New  Construction    176,137,166 

Increase  in  surplus 82,223,107 


$293,352,095 


115.  Operating  policy, — A  careful  study  of  the  op- 
erating policy  of  the  steel  corporation  belongs  elsewhere. 
Our  attention  may  be  turned,  however,  to  a  few  con- 
spicuous facts, 


THE  UNITED  STATES  STEEL  CORPORATION     219 

The  corporation's  relations  with  its  employes  have 
so  far  been  exceptionally  harmonious.  There  has  been 
no  strike  or  serious  trouble  of  any  kind.  At  the  end  of 
1902  the  corporation  started  its  famous  profit-sharing 
plan  under  which  a  large  amount  of  preferred  stock  has 
been  sold  to  employees.  The  workers  are  divided  into 
six  classes,  according  to  salary,  and  each  class  is  allowed 
to  buy  a  certain  proportion  of  stock  each  year  at  a  fixed 
price.  The  prices  named  have  always  been  somewhat 
below  the  market  prices.  The  corporation  gives  a 
bonus  of  $5  for  each  share,  which  is  held  for  five  years. 
The  result  has  been  to  give  a  considerable  number  of  the 
210,000  employees  a  lively  interest  in  the  success  of  the 
corporation,  and  to  bind  them  more  closely  to  the  man- 
agement. The  scheme  has  proved  practicable  and  has 
been  probably  of  great  benefit  in  maintaining  industrial 
peace. 

The  corporation  is,  of  course,  simply  a  holding  com- 
pany and  has  only  a  general  oversight  over  the  sub- 
companies.  Each  subsidiary  company  manages  its  own 
internal  affairs  and  buys  and  sells  from  and  even  com- 
petes with  other  sub-companies.  Cross  shipments,  how- 
ever, are  avoided  and  raw  materials  are  furnished  by 
common  agencies.  The  idea  is  to  stimulate  each  com- 
pany by  internal  competition  and  otherwise  to  the 
highest  pitch  of  efficiency.  The  operating  ratio  or  per 
cent  of  manufacturing  costs  to  gross  business  has  been 
very  steady  with  a  slight  tendency  downward  since  1902. 
The  ratio  has  not  moved  up  very  high  in  periods  of  de- 
pression, which  is  considered  an  indication  of  econom- 
ical management. 

116.  Steel  securities. — The  securities  of  the  United 
States  Steel  Corporation  now  outstanding  are: 


220  CORPORATION  FINANCE 

1— Underlying  bonds $    107,155,749 

2— Coll.  Tr.  Gold  5's,  1901   288,798,000 

S—  "        "     Skg.  Fd.  5's,  1903 204,231,521 

Total  Bonds    $    600,185,270 

4— Preferred  Stock    360,281,100 

5— Common   Stock .         508,302,500 

Total  Securities    $1,468,768,870 

The  underlying  bond  issues  are  too  numerous  and  too 
small  in  volume  to  be  worth  discussing  here.  Most  of 
them  are  secured  by  direct  first  mortgages  and  are  very 
closely  held. 

The  collateral  trust  gold  5's  of  1901,  due  April  1, 
1915,  are  secured  by  the  deposit  of  all  the  securities 
owned  by  the  corporation.  A  sinking  fund  of  $3,040,- 
000  per  year  is  used  to  purchase  bonds  obtainable  at  115 
or  less,  and  after  April  1,  1911,  may  be  applied  to  the 
redemption  of  bonds  to  be  drawn  by  lot.  Almost  all 
these  bonds  are  held,  it  is  understood,  by  Andrew  Car- 
negie and  are  not  on  the  market. 

A  more  interesting  issue  to  us  is  the  collateral  trust 
sinking  fund  10-60  year  gold  5's  of  1903.  The  autho- 
rized issue  was  $250,000,000,  of  which  $200,000,000  was 
reserved  for  exchange  with  preferred  stock  under  the 
conversion  plan.  As  a  claim  on  the  assets,  these  bonds 
rank  next  to  the  5's  of  1901.  They  are  further  pro- 
tected by  a  sinking  fund  of  $1,010,000  per  annum  to  be 
used  until  1913  for  the  purchase  of  bonds  at  110  or  less 
and  after  1913  for  the  redemption  of  bonds,  drawn  by 
lot,  at  110.  This  last  named  feature  introduces  a 
speculative  element  into  the  security  which  is  supposed 
to  enhance  its  value.  If  the  estimates  already  quoted  of 
the  asset  value  of  the  property  of  the  corporation  are 


A 


THE  UNITED  STATES  STEEL  CORPORATION      221 

correct,  these  bonds  have  behind  them  chiefly  the  earning 
power  of  the  corporation. 

The  preferred  stock  issue  is  7  per  cent  cumulative. 
Dividends  have  not  been  missed  since  the  formation  of 
the  corporation.  The  common  stock  drew  4  per  cent 
in  the  first  two  years;  %  per  cent  in  1903;  nothing  from 
that  date  till  1906;  1%  V^^  ^^^^  i^  1906;  and  2  per  cent 
since  then.  It  is  expected  to  maintain  its  2  per  cent 
rate. 

Steel  has  been  a  prince  now  for  several  years.  Is  it 
likely  to  become  so  much  of  a  pauper  that  dividends  or 
even  interest  will  be  threatened?  There  can  be  no  doubt 
but  that  the  corporation  is  still  in  danger;  a  bad  slump 
or  even  insolvency  is  conceivable.  On  the  other  hand, 
there  are  at  least  two  good  reasons  for  believing  that 
the  danger  is  rapidly  lessening  and  in  a  few  years  will  be 
a  thing  of  the  past. 

One  of  these  reasons  is  that  the  physical  condition  of 
its  properties  is  excellent,  according  to  all  reports,  and 
is  being  constantly  improved.  We  have  already  alluded 
to  the  large  appropriations  for  depreciation  and  for  bet- 
terments. It  is  estimated  that  by  the  partial  completion 
of  the  Gary  plant,  the  capacity  of  the  corporation  has 
been  increased  75  per  cent;  yet  the  interest  charges  are 
practically  the  same  as  they  were  at  the  beginning.  In 
addition,  new  ore  deposits,  it  is  said,  of  a  value  of  $400,- 
000,000  have  been  located  on  the  lands  of  the  Steel 
corporation.  The  second  reason  is  that  the  demand  for 
steel  in  this  country  is  apparently  insatiable.  Steel  rail 
production  to-day  is  nearly  three  times  that  of  1881 ;  yet 
this  particular  kind  of  product  which  was  of  great  im- 
portance in  1881  is  now  only  a  fraction  of  the  entire 
steel  trade.  The  demand  for  structural  shapes  and  for 
machinery,  already  enormous,  is  just  beginning  to  grow. 


^2  CORPORATION  FINANCE 

To  get  an  idea  of  what  may  be  expected  in  the  next  ten 
or  twenty  years,  let  us  observe  the  per  capita  increase  in 
the  production  of  pig  iron  in  the  last  twenty-eight  years 
as  shown  below: 

1880  171  pounds 

1890 329       " 

1900 399       " 

1905  619       " 

1906 662       " 

That  the  corporation  managers  have  faith  in  the  fu- 
ture of  the  steel  trade  and  of  the  Steel  Corporation  is 
evident  from  their  contract  with  the  Hill  ore  interests. 
The  contract  pledges  the  corporation  to  a  minimum 
output  of  8,250,000  tons  of  ore  in  1917  at  a  royalty  of 
$16,417,500  per  year.  Of  course  the  corporation  does 
not  expect  to  let  its  own  ore  lie  idle.  It  evidently  in- 
tends to  expand  its  business  enormously. 

If  the  steel  business,  then,  grows,  as  the  biggest  and 
most  f  arsighted  men  in  that  line  expect,  and  if  the  pres- 
ent policy  of  improvement  and  enlarging  the  proper- 
ties continues,  as  there  is  no  reason  to  doubt,  we  may 
safely  conclude  that  the  earnings  of  the  steel  corpora- 
tion will  become  very  much  larger  than  they  are  now. 
Of  course,  those  earnings  will  not  grow  continuously. 
The  steel  business  is  speculative  and  erratic  in  its  very 
nature  and  always  will  be,  so  long  as  periods  of  depres- 
sion and  of  prosperity  alternate.  Yet  the  enterprise  and 
efficiency  of  the  United  States  Steel  managers  seem  to 
be  almost  a  guarantee  that  at  the  worst  steel  earnings 
will  never  sink  so  low  that  interest  charges  cannot  be 
met;  it  is  reasonable  to  expect  that  they  will  never 
sink  so  low  that  preferred  dividends  cannot  be  met ;  and 
it  is  even  reasonable  to  hope  that  the  common  dividends 
will  always  be  maintained  at  or  above  their  present  level* 


CHAPTER  XVI 

SELLING  SECURITIES— THE  PROSPECTUS 

117.  The  four  methods  of  selling  securities, — ^When- 
ever new  securities — whether  of  an  estabUshed  company, 
of  a  new  concern  or  of  a  reorganization — are  issued, 
these  are  four  possible  methods  of  disposing  of  them. 
The  first  method  is  by  an  inside  distribution  of  the  se- 
curities to  people  already  interested  in  the  business.  This 
method  we  have  already  considered.  In  the  case  of  a 
close  corporation  the  distribution  of  the  securities  is  ob- 
viously a  simple  matter  of  bargain-making  among  the 
few  people  involved.  In  the  case  of  a  consolidation 
the  distribution  to  insiders  is  carried  on  by  exchanging 
the  new  securities  for  old  securities  as  already  explained. 

The  second  method  is  to  work  through  the  Wall 
Street,  or  some  similar,  market,  which  is  consideredTui 
the  chapter  following. 

The  third  method  is  to  sell  them  to  the  public  through 
established  bondorjbrokerage  houses.  This  method  will 
be  discussed  both  in  this  chapter  and  under  the  head  of 
underwriting. 

The  fourth  method  is  by  ^rect  appeal  to  the  public 
through  newspaper  and  magazine  advertising,  through 
circular  and  individual  letters  and  through  salesmen. 
In  a  great  many  corporations  the  promoter  finds  the 
first  three  methods  unavailable  and  is  forced  to  resort 
to  this  fourth  method.  This  is  particularly  true  of 
speculative  enterprises. 

The  principles  that  should  be  followed  in  the  presen- 


224  CORPORATION  FINANCE 

tation  and  selling  of  corporate  securities  direct  to  the 
public  are  not  different  from  the  principles  that  should 
be  followed  in  selling  other  articles.  These  principles 
are  treated  in  the  volume  on  Business  Organization 
and  need  not  be  reviewed  here.  Something  should  be 
said,  however,  about  the  document  in  which  the  leading 
facts  with  regard  to  the  securities  are  stated  and  the  pros- 
pects of  the  company  discussed,  namely,  the  prospectus. 

118.  General  characteristics  of  a  good  prospectus, — 
The  promoter's  prospectus  should  be  and  with  successful 
flotations  always  is  a  work  of  art.  A  good  prospectus 
will  appeal  to  a  large  number  of  people,  will  arouse 
their  interest,  will  hold  their  attention  from  beginning 
to  end,  and  will  engender  confidence.  A  poor  prospec- 
tus will  nullify  whatever  success  the  promoter  may  have 
had  in  stimulating  curiosity  on  the  part  of  the  prospec- 
tive buyers  of  his  securities. 

It  goes  without  saying  that  it  should  be  well  written 
and  attractively  printed.  In  this  respect  the  same  rules 
that  apply  to  other  selling  literature  should  be  followed. 

Naturally  the  prospectus  will  emphasize  the  strong 
features  and  minimize  the  weak  spots  of  the  business. 
The  promoter  must  take  care,  however,  in  so  doing  that 
he  does  not  misstate  or  conceal  any  material  fact. 
Otherwise  he  may  be  held  liable  for  fraud,  or  at  least 
anyone  who  subscribes  to  the  corporation's  securities  on 
the  strength  of  the  prospectus  may  have  good  legal 
grounds  for  withdrawing  from  his  contract.  The  skill- 
ful prospectus  writer,  who  is  presenting  to  the  public 
securities  which  he  knows  to  be  highly  speculative  in 
character,  must  find  some  means  of  reconciling  these 
comparatively  inconsistent  requirements.  He  must  pre- 
sent all  the  important  facts  and  yet  he  must  make  his 
prospectus    strong,    attractive    and    convincing.     Any 


SELLING  SECURITIES— THE  PROSPECTUS     225 

well-trained  writer  should  be  able  to  do  the  trick  if  he 
chooses. 

Obviously  in  any  prospectus  the  strikingly  attractive 
features  of  the  enterprise  will  be  made  prominent  and 
much  will  be  said  about  them.  Perhaps  the  statements 
with  regard  to  them  will  be  printed  in  bold  face  or  other 
prominent  type,  so  as  to  catch  the  eye  of  the  reader  at 
once.  Statements  as  to  the  more  doubtful  and  risky 
features  of  the  enterprise  will  be  tucked  away  in  some 
obscure  corner.  Thus  the  law  will  be  satisfied  and  at 
the  same  time  it  will  take  a  very  careful,  intelligent  read- 
ing to  ascertain  from  the  prospectus  the  real  facts  of 
the  case. 

Another  means  of  avoiding  legal  objections  is  to 
make  sweeping  general  statements  without  making  the 
writer  or  any  other  definite  person  responsible  for  them. 
Such  phrases  as  "competent  judges  have  reported,"  or 
"after  expert  examination  we  believe,"  or  "witnesses 
who  have  seen  the  property  are  thoroughly  convinced," 
are  very  common  introductions  in  prospectuses.  The 
statements  in  themselves  may  be  untrue;  yet  by  using 
such  phrases  the  writer  may  succeed  in  divesting  himself 
of  any  personal  responsibility. 

Most  prospectuses,  as  any  reader  of  them  will  testify, 
are  so  vague,  that  what  the  writer  implies  assumes  a 
much  more  prominent  place  in  the  average  reader's  mind 
than  what  he  actually  says.  In  a  recent  mining  pros- 
pectus, for  instance,  we  have  the  following  typical 
sentence:  "We  have  every  reason  to  believe  that  the 
corporation  will  have  assets  at  the  end  of  the  year  that 
will  astonish  each  and  every  holder  of  the  stock,  and  it 
is  our  belief  that  claims,  titles  and  rights  cannot  be 
bought  outright  for  $1,000,000  or  more."  Notice  that 
this  sentence  does  not  contain  any  single  statement  of 

1—15 


2S6  CORPORATION  FINANCE 

fact  to  which  the  prospectus-writer  could  be  bound  down. 

Another  hoary  trick  that  is  worked  over  and  over 
again  in  the  prospectuses  of  new  companies,  is  to  call 
attention  to  the  immense  profits  of  other  companies 
working  in  the  same  field.  It  is  very  seldom  indeed  that 
a  copper-mining  prospectus  is  issued  that  does  not  call 
attention  in  big  type  to  the  profits  made  by  the  holders 
of  the  original  stock  of  Calumet  and  Hecla,  the  Copper 
Queen,  Anaconda,  and  other  classic  examples.  The 
reader  is  expected  to  infer  that  the  new  corporation  will 
have  a  similar  history. 

119.  ^  typical  speculative  prospectus, — The  pros- 
pectus of  a  company  designed  to  own  and  publish  a 
magazine  is  given  in  part  below.  The  reader  will  find 
in  these  few  paragraphs  illustrations  of  all  the  principles 
mentioned  above.  In  this  case,  although  the  magazine 
is  stated  to  have  been  in  existence  for  twenty-eight 
years,  not  one  word  is  said  as  to  its  record;  instead,  all 
the  emphasis  is  given  to  "prospects,"  "purpose"  and 
"possibilities." 

It  is  a  medium  that  can  treat  any  subject  with  justice  to  it- 
self and  its  readers;  therefore,  its  pulling  power  for  subscrip- 
tions, you  will  agree,  covers  possibly  a  greater  field  for  circula- 
tion, than  any  magazine  that  you  can  recall.  Its  field  of  expan- 
sion is  simply  unlimited. 

From  an  advertising  standpoint,  I  might  say,  after  years  of 
experience,  I  do  not  know  of  a  publication  that  has  such  pros- 
pects for  money  making  as  The  Blank  Company. 

Being  a  practical  publisher,  it  is  my  purpose  to  put  The 
Blank  Company  in  the  place  it  should  enjoy,  and  in  order  to  do 
this,  I  have  deemed  it  wise  to  share  its  future  with  a  number  of 
my  friends,  and  am,  therefore,  organizing  a  company  capitalized 
at  $50,000  for  the  immediate  expansion  of  The  Blank  Company. 
The  stock  is  secured  by  the  property,  the  name  and  the  good 
will,  which,  if  put  up  at  auction,  would  be  considered  a  bargain, 


A 


SELLING  SECURITIES— THE  PROSPECTUS       ^27 

if  purchased  at  many  times  the  amount  of  the  company's  cap- 
italization. 

If  you  have  looked  into  the  magazine  field,  you  will  know  that 
although  some  of  the  larger  magazines  are  capitalized  for  over 
a  half-million  dollars,  they  are  all  making  phenomenal  money 
for  their  early  investors.  The  general  magazine  field  I  consider 
pretty  well  covered,  but  a  magazine  of  the  unique  name  that  The 
Blank  Company  possesses,  can  be  expanded  and  developed  and 
larger  profits  made  from  it  than  any  other  publication  enjoys. 

To  illustrate  the  earning  power  of  magazines,  permit  me  to 
say  that  one  magazine  was  sold  some  time  ago  to  a  well-known 
newspaper  publisher  for  nearly  $700,000,  in  spite  of  the  fact 
that  at  that  time  it  had  a  circulation  of  only  250,000  and  a 
shrinking  in  its  advertising  patronage. 

Another  well-known  magazine,  whose  circulation  had  dropped 
down  below  50,000  and  had  practically  no  advertising,  declined 
an  offer  of  $10,000  for  its  name  and  good  will. 

I  will  recall  that  if  you  had  been  able  to  buy  a  thousand 
dollars  worth  of  Munsey's  stock,  on  the  ground  floor  basis  (that 
you  are  now  offered  in  The  Blank  Company)  for  your  invest- 
ment the  thousand  dollars  in  Munsey*s  now  would  be  paying  you 
$10,000  to  $12,000  a  year  in  dividends. 

If  you  could  have  invested  only  $100  in  Munsey'^s,  your  hold- 
ings would  now  be  worth  from  ten  to  twelve  thousand  dollars 
and  would  be  paying  you  $1,000  to  $1,200  a  year  in  dividends ; 
a  larger  investment  would  have  made  you  wealthy. 

An  English  author,  who  ten  years  ago  obtained  $2,000  worth 
of  McClure*s  Magazine  stock  in  exchange  for  a  manuscript,  sold 
his  holdings  recently  for  $20,000,  having  received  in  dividends 
during  that  time  the  round  sum  of  $14,000.  For  his  $2,000 
worth  of  manuscript  he  received  in  a  decade  $34,000  in  cash,  a 
profit  of  1,700  per  cent. 

Everybody^  The  Ladies*  Home  Journal  and  many  other 
magazines,  represent  wonderful  money-making  investments. 

The  same  opportunity  is  knocking  at  your  door  at  this  mo- 
ment. The  Blank  Company,  with  its  twenty-eight  years  of 
continuous  existence,  with  an  unlimited  advertising  field  and  with 


S28  CORPORATION  FINANCE 

a  subscription  list  that  can  be  increased  beyond  that  of  any  other 
publication  in  existence,  offers  you  a  rare  opportunity  in  asso- 
ciating yourself  with  an  enterprise  which  will  make  money  for 
its  stockholders  very  rapidly. 

If  you  want  to  go  in  with  me  in  developing  and  expanding 
The  Blank  Company,  I  will  offer  you  some  of  its  stock  at  its 
par  value,  $10  per  share.  This  opportunity,  however,  will  only 
remain  open  for  a  short  while.  Stock  can  be  purchased  on  a 
basis  of  3  per  cent  for  cash  with  subscription,  or  10  per  cent 
down  and  10  per  cent  per  month. 

120.  A  typical  investment  prospectus, — In  the  above 
remarks  we  have  had  in  mind  principally  the  pros- 
pectuses of  highly  speculative  companies.  We  need  not 
pass  judgment  here  on  the  legitimacy  of  the  methods 
that  are  used  by  such  companies  to  obtain  subscriptions 
for  their  stock.  It  is  certainly  improper  to  delude 
subscribers.  On  the  other  hand,  it  is  unquestionably 
proper  to  present  a  new  enterprise  in  a  favorable  light. 
Just  where  the  dividing  line  between  an  honestly  favor- 
able and  a  dishonestly  deceptive  presentation  comes  is  a 
question  which  every  promoter  must  settle  with  his  own 
conscience.  The  prospectuses  of  well-known,  entirely 
legitimate  investment  securities  often  go  to  the  other 
extreme.  They  present  merely  a  dry,  formal  statement 
of  the  facts  with  sometimes  a  tabulation  of  the  assets 
and  earnings  of  the  company  or  bald  figures  of  some 
other  kind. 

For  instance,  several  of  the  leading  banks  of  the 
world — including  Baring  Brothers  and  Company  of 
London,  Comptoir  National  d'Escompte  de  Paris, 
Credit  Lyonnais  of  Paris,  Deutsche  Bank  of  Berlin,  J. 
P.  Morgan  and  Company,  the  First  National  Bank  and 
the  National  City  Bank  of  New  York — co-operated  in 
issuing  on  March  1,  1909,  a  $50,000,000  5  per  cent 


SELLING  SECURITIES— THE  PROSPECTUS      229 

internal  gold  loan  of  the  Argentine  Government. 
Much  might  have  been  said  as  to  the  wealth,  high  stand- 
ing and  prospects  of  the  Argentine  Republic  and  as  to 
the  small  amount  of  the  loan  in  comparison  with  the 
great  resources  back  of  it.  The  bonds  were  sold  at  the 
price  of  99  per  cent  of  the  face  value,  thus  yielding  to 
the  purchaser  something  over  5  per  cent,  a  high  rate 
on  the  loans  of  a  government  of  good  standing.  We 
can  imagine,  taking  the  examples  that  have  been  given 
above  as  a  basis,  how  a  promoter  used  to  getting  up 
prospectuses  for  speculative  concerns  would  have 
reveled  in  the  opportunities  that  this  issue  would  have 
afforded  him,  how  he  would  have  enlarged  on  the 
Argentine  Republic's  reputation  and  prosperity,  how 
many  word  pictures  he  would  have  drawn  to  illustrate 
his  statements. 

The  prospectus  issued  by  the  great  banks  that  have 
been  named,  however,  compressed  a  description  of  the 
bonds,  a  statement  of  the  terms  on  which  they  would  be 
issued,  and  the  argument  on  behalf  of  the  bonds  into 
the  four  brief,  cold  paragraphs  that  follow: 

Provision  is  made  for  a  sinking  fund  of  1  per  cent.  By  the 
operation  of  this  sinking  fund  the  loan  will  be  paid  off  in 
thirty-six  years  at  the  latest.  The  contract  with  the  Argentine 
Government  provides  that  said  fund  is  to  be  applied  half  yearly 
to  the  purchase  or  tender  of  bonds  at  or  under  par  or  by  draw- 
ings at  par  should  the  bonds  be  at  over  par.  The  first  operation 
of  the  sinking  fund  will  take  place  in  the  month  of  December, 
1909.  Drawn  bonds  will  be  payable  on  March  1st  or  Septem- 
ber 1st  following  the  date  of  the  drawing.  The  Government 
undertakes  not  to  increase  the  sinking  fund  or  to  redeem  the 
whole  of  the  loan  before  March  1st,  1914. 

We  reserve  to  ourselves  the  absolute  right  in  our  discretion 
to  close  the  application  list  at  any  time  without  notice  and  to 


230  CORPORATION  FINANCE 

reject  any  or  all  applications  and  also  to  allot  smaller  amounts 
than  applied  for. 

All  applications  should  be  made  on  forms  which  may  be  ob- 
tained at  our  offices,  and  must  be  accompanied  by  a  deposit  of 
$50  per  bond. 

If  no  allotment  is  made,  the  deposit  will  be  returned  in  full, 
and  if  only  a  portion  of  the  amount  applied  for  be  allotted,  the 
balance  of  the  deposit  will  be  appropriated  towards  the  amount 
due  on  March  10th,  1909.  If  any  further  balance  remains, 
such  balance  will  be  returned.  In  case  of  failure  to  pay  the 
balance  of  the  subscription  when  due,  all  right  in  any  previous 
payment  will  vest  in  us  absolutely  without  accountability  there- 
for. 

Although  such  a  presentation  is  unattractive,  it  is 
frequently  effective.  The  coldness  and  dryness  carry 
with  them  the  sense  of  conservative  safety.  For  that 
reason,  a  statement  of  this  kind  is  sometimes  put  for- 
ward as  a  prospectus  of  what  is  in  reality  a  highly 
speculative  company;  and  this  trick  when  skillfully 
executed  has  been  known  to  succeed. 

121.  The  ideal  prospectus, — Even  in  the  most  formal 
prospectus,  however,  it  is  usually  well  to  use  untechnical 
expressions  and  to  present  facts  in  such  a  manner  that 
they  will  be  not  merely  significant,  but  interesting. 
Some  such  tendency  is  coming  into  evidence,  even  in 
the  presentations  of  strictly  investment  securities.  The 
number  of  people  who  are  possible  investors  in  such 
securities  is  constantly  increasing  and  the  amount  of 
such  securities  is  also  increasing.  In  order  to  create  a 
market  for  these  immense  issues  among  people  who  are 
not  familiar  with  the  technical  jargon  of  the  financial 
world,  it  is  necessary  to  change  somewhat  the  old- 
fashioned  formal  method  of  presentation.  This  change 
is  undoubtedly  for  the  better.     As  the  intelligent  in- 


SELLING  SECURITIES— THE  PROSPECTUS      231 

terest  of  the  public  in  financial  affairs  grows,  we  may 
expect  to  see  the  typical  prospectus  of  a  speculative 
corporation  and  the  presentation  of  a  strictly  investment 
security  approaching  each  other  more  closely  in  tone  and 
in  form. 

Although  in  this  country  the  prospectus,  as  has  been 
indicated,  is  so  frequently  used  to  present  speculative 
and  even  swindling  schemes  in  a  false  light  that  pros- 
pectus-writing has  come  to  be  regarded  almost  as  a 
dishonorable  method  of  securing  money  for  an  enter- 
prise, and  although  this  opinion  is  not  without  basis,  yet 
it  must  be  borne  in  mind,  on  the  other  hand,  that  there 
are  such  things  as  a  legitimate  direct  appeal  to  the  public 
for  funds  and  an  honest  prospectus. 

In  England  this  method  of  raising  funds  is  much 
more  generally  used  for  reputable  enterprises  than  in 
this  country.  To  take  one  instance,  it  is  said  that  the 
English  Eastman  Kodak  Company  was  floated  with- 
out any  assistance  whatever  from  bankers  or  under- 
writers. About  $5,000,000  of  stock  was  sold  to  the 
public  through  direct  newspaper  advertising,  circulariz- 
ing and  the  issue  of  an  attractive  prospectus.  That  the 
method  in  this  instance  has  been  entirely  successful  is 
shown  by  the  fact  that  the  company's  stock  is  now  selling 
at  the  rate  of  about  $675  a  share.  It  is  to  be  regretted 
that  the  number  of  similar  instances  in  this  country  is 
so  small. 

122.  Selling  through  banking  houses, — The  securities 
of  almost  all  large  legitimate  corporations  are  sold 
through  banks  and  brokerage  houses.  The  advantage 
of  this  method  to  the  investor  is  that  he  is  protected  more 
or  less  by  the  investigation  and  experienced  judgment  of 
his  banker.  The  disadvantages  are  three:  first,  on  ac- 
count of  his  leaving  the  investigation  to  the  banker  he 


^2  CORPORATION  FINANCE 

does  not  acquire  that  first-hand  knowledge  of  the  enter- 
prise in  which  he  invests  that  it  would  be  desirable  for 
him  to  obtain;  second,  that  he  is  thus  left  practically 
at  the  mercy  of  his  banker ;  third,  that  the  broker's  com- 
mission, which  is  often  not  inconsiderable,  intervenes 
between  the  buyer  of  the  security  and  the  selUng  corpo- 
ration. 

The  advantage  to  the  corporation  of  selling  through 
a  bank  or  brokerage  house  is  that  the  corporation 
officials  may  feel  certain  that  the  issue  will  be  success- 
fully disposed  of  in  this  way,  especially  if  it  is  "under- 
written," as  explained  in  Chapter  XVIII.  With  a 
corporation  of  any  size,  the  bond  or  brokerage  house 
will  probably  be  one  of  the  large  concerns  that  carry 
on  their  work  in  the  Wall  Street  district  of  New  York, 
the  State  Street  district  of  Boston,  the  La  Salle  Street 
district  of  Chicago,  or  the  corresponding  financial  center 
of  some  other  large  city. 

123.  Requirements  of  reputable  banking  houses, — 
The  good  Wall  Street  houses  will  not  undertake  to  float 
issues  of  small  size — certainly  none  less  than  $100,000 
and  preferably  not  that  small — for  two  reasons;  first, 
because  there  is  not  enough  profit  in  selling  small  issues 
to  pay  for  the  expenses ;  second,  because  a  small  issue  of 
stocks  or  bonds  never  becomes  well-known  to  the  public 
and  is  therefore  not  readily  marketable.  As  to  the  kinds 
of  enterprises  that  will  be  taken  up,  the  better  houses  pre- 
fer in  the  order  named,  steam  railroads,  electric  rail- 
roads and  industrials.  Most  of  them  will  not  touch 
mines,  oil  companies,  or  any  other  highly  speculative 
enterprise.  The  only  practicable  means  for  getting 
funds  for  such  an  enterprise  from  the  public  ordinarily 
is  by  direct  solicitation. 

There  are  not  many  high-class  Wall  Street  houses 


I 


SELLING  SECURITIES— THE  PROSPECTUS      233 

engaged  in  selling  securities  and  there  are  a  considerable 
number  of  imitation  banking  houses  whose  main  object 
is  to  get  their  hands  on  the  money  of  "suckers."  The 
working  plan  of  such  swindlers  is  to  receive  persons  who 
come  to  them  with  securities  to  sell,  no  matter  how 
worthless  the  securities  may  be,  with  open  arms,  wax 
enthusiastic  over  the  market  for  the  securities,  make 
numerous  high-sounding  promises  as  to  the  sales  which 
they  will  be  able  to  make,  and  in  conclusion  demand 
from  the  victim  as  his  "guarantee  of  good  faith"  a  sum 
of  money  for  expenses.  Of  course  this  money  is  not 
honestly  spent.  The  high-grade  banking  houses,  on  the 
contrary,  will  receive  any  new  proposition  that  is  pre- 
sented to  them,  especially  if  it  comes  from  a  stranger, 
with  skepticism ;  and,  if  they  show  any  interest  at  all,  it  is 
to  be  expected  that  they  will  make  a  long  and  thorough 
investigation,  before  committing  themselves  in  any 
manner.  It  is  poor  policy  to  approach  one  of  these 
houses  without  having  a  business  introduction  of  some 
kind.  Generally  speaking,  it  is  well  to  present  the 
proposition  in  writing  in  the  first  place,  giving  a  clear 
and  complete  statement  with  all  the  supporting  evidence 
that  can  be  added.  A  Wall  Street  banker  of  the  class 
that  the  writer  has  in  mind  is  not  likely  to  be  carried 
off  his  feet  by  persuasive  personal  eloquence  and  is  more 
likely  to  yield  to  cold  figures  than  to  impassioned 
appeals. 

It  takes  a  man  who  has  spent  a  lifetime  in  the  Street 
to  tell  absolutely  what  are  the  sound,  reliable  houses  and 
what  are  the  more  or  less  shady  concerns.  There  are 
Wall  Street  firms  which,  to  the  writer's  knowledge,  are 
regarded  by  Wall  Street  bankers  as  worse  than  banditti, 
which  nevertheless  have  kept  in  existence  and  have 
apparently   been   prosperous    for   many   years.     Such 


2M  CORPORATION  FINANCE 

firms  may  maintain  expensive  suites  of  offices,  may  have 
pious-looking  personages  at  their  head  and  may  give 
an  appearance  of  permanence  and  honesty.  The  only 
sure  sign  of  their  general  unreliability,  that  the  writer 
can  give,  is  that  they  are  out  looking  for  business,  that 
they  make  an  effort  to  secure  for  themselves  the  flota- 
tion of  securities  of  small  corporations  and  that  they  are 
willing  to  pretend  to  sell  such  securities  without  having 
first  made  an  adequate  investigation.  Even  this  symp- 
tom, however  is  not  always  present,  for  the  heads  of  such 
concerns  are  shrewd  and  experienced  enough  to  make  a 
pretense  at  times  of  conducting  an  investigation  before 
they  accept  the  proposition  that  has  been  presented  to 
them. 

The  first  step  in  the  investigation  of  an  enterprise 
by  a  reputable  house  will  be  to  get  the  complete  record 
of  all  the  men  who  have  any  connection  with  it.  If 
there  is  a  flaw  in  the  reputation  of  any  of  them,  the 
whole  proposition  will  probably  be  dropped.  Next,  the 
prospects  of  the  enterprise  itself  will  be  looked  into. 
Every  large  house  engaged  in  selling  securities  keeps 
on  its  own  staff  capable  men  who  are  qualified  to  form 
an  expert  judgment  as  to  the  merits  of  the  common 
forms  of  business  enterprises,  such  as  street  railroads, 
manufacturing  plants,  and  so  on.  In  addition,  unless 
the  house  is  absolutely  satisfied,  it  will  probably  obtain 
reports  based  on  searching  examinations  by  three  classes 
of  professional  experts,  namely,  engineers,  lawyers  and 
accountants.  If  all  of  these  are  favorable,  from  begin- 
ning to  end,  the  proposition  will  perhaps  be  accepted. 

The  three  essential  factors  in  making  a  proposition 
acceptable  are: 

(1)  Good  reputation  of  the  men  connected  with  the 
enterprise. 


SELLING  SECURITIES— THE  PROSPECTUS      ^35 

(2)  Absence  of  risky  factors  in  the  general  nature  of 
the  business  or  in  the  general  situation.  For  instance,  a 
street  railway  company  would  not  be  taken  up  if  the 
people  of  the  locality  in  which  it  had  been  located  were 
for  some  reason  bitterly  hostile  to  public  service  corpo- 
rations. In  the  same  way,  as  has  been  said,  the  good 
banking  houses  will  not  deal  in  the  securities  of  unde- 
veloped mines,  no  matter  how  promising. 

(3)  Practical  certainty  of  profits  sufficient  to  meet 
all  fixed  charges.  This  almost  goes  without  saying; 
yet  it  is  worth  noting,  because  many  people  seem  to  im- 
agine that  if  a  new  corporation  promises  to  have  consid- 
erable profits  its  securities  are  safe  investments.  It  is 
necessary  that  these  profits  should  not  only  be  large  in 
the  aggregate,  but  should  be  steady  enough  and  certain 
enough  to  guarantee  that  the  corporation  will  never  be 
compelled  to  pass  any  of  its  interest  payments  or  other 
fixed  charges. 

124.  Their  methods  of  selling  securities, — The  good 
Wall  Street  houses  are  so  exceedingly  careful  in  their 
investigations  because  they  sell  most  of  the  securities 
they  handle,  not  to  the  public  at  large  through  adver- 
tising and  through  wide  distribution  of  prospectuses, 
but  to  a  comparatively  small  number  of  their  clients. 
These  clients  include  not  only  individuals,  some  of  whom 
have  regular  sums  to  invest  every  year,  but  also  such 
institutions  as  insurance  companies,  saving  banks  and 
trust  companies.  It  is  necessary  in  order  to  hold  this 
clientele  that  the  house  should  establish  and  maintain 
a  reputation  for  the  strictest  integrity  and  conservatism. 
So  long  as  this  reputation  is  maintained  there  is  seldom 
any  difficulty  in  selling  whatever  securities  the  house 
may  accept.     The  following  extract  from  an  article  in 


2S6  CORPORATION  FINANCE 

the  "Bond  Buyers'  Dictionary"  gives  further  details  as 
to  the  methods  of  such  houses. 

It  is  through  the  retail  bond  dealers  that  the  great  investing 
public  of  the  country  is  reached.  The  other  day  a  retired  mer- 
chant died  in  Pittsburg  whose  wealth  was  estimated  by  bankers 
to  exceed  $50,000,000.  Of  the  several  million  persons  who  read 
of  his  death  in  the  newspapers  the  following  morning  only  a 
few  had  ever  heard  his  name  before.  There  are  thousands  of 
similar  capitalists  in  the  United  States,  each  possessing  a  for- 
tune greater  than  was  owned  by  any  single  individual  in  the 
country  fifty  years  ago,  whose  names  are  entirely  unknown  to 
the  average  newspaper  reader.  There  are  several  hundred 
thousand  others  who  possess  independent  fortunes.  It  is  with 
these  individual  investors  that  the  retail  bond  merchant  deals. 
All  have  a  large  list  of  wealthy  customers,  to  which  they  are 
continually  adding.  The  customers  of  some  are  mostly  in  New 
York  or  Pennsylvania,  of  others  in  New  England,  of  others  in 
Canada,  of  others  in  the  West  or  the  South.  Some  have  wealthy 
foreign  customers. 

The  number  of  regular  customers  may  range  from  5,000 
to  as  high  as  25,000.  There  is  one  retail  bond  house  in  Wall 
Street,  which  has  been  in  business  for  seventy-five  years,  that 
has  a  list  which  could  not  be  purchased  for  several  million  dol- 
lars. It  includes  22,000  names,  and  these  customers  purchase,  on 
an  average,  nearly  $5,000  of  bonds  a  year  apiece,  or  a  total  of 
more  than  $100,000,000  a  year.  This  house  would  not  hesitate 
to  purchase  a  block  of  $5,000,000  or  $10,000,000  or  even  $20,- 
000,000,  of  municipal,  county,  or  railroad  bonds,  knowing  that^ 
it  would  be  able  to  dispose  of  the  entire  block  in  the  course  of 
few  months  in  small  lots  to  its  regular  customers. 

Practically  every  large  retail  bond  house  in  Wall  Street  now] 
employs  salesmen,  who  travel  over  the  country  selling  bonds, 
very  much  as  drummers  sell  tea  or  coffee.  Some  of  the  largest] 
houses  employ  as  many  as  forty  salesmen ;  altogether,  more  than 
300  are  employed  in  Wall  Street.  Each  has  his  own  territory 
and  possesses  his  own  customers.     Many  make  salaries  of  from 


SELLING  SECURITIES— THE  PROSPECTUS   S3T 

$10,000  to  $15,000  a  year,  and  some  even  more.  All  are,  to 
some  extent,  experts  on  values.  In  addition  to  employing  sales- 
men the  retail  bond  houses  advertise  extensively. 

The  reputation  of  a  bond  house,  and  the  following  which  it 
possesses  among  investors,  is  its  principal  stock  in  trade.  The 
majority  of  the  customers  of  a  bond  house  purchase  securities 
from  it,  not  because  of  personal  and  expert  knowledge  of  the  se- 
curity and  safety  of  the  bonds,  but  because  of  the  reputation 
of  the  house.  The  average  investor  whether  he  invests  $5,000 
or  $500,000  a  year,  after  a  superficial  examination,  purchases 
securities  almost  entirely  on  the  recommendation  of  his  bond 
dealer.  The  enormous  profits  the  bond  dealers  make  is  the 
price  they  charge  for  lending  this  credit  to  corporations  and 
municipalities.  Practically  every  one  of  the  leading  Wall 
Street  bond  houses  may  boast  that  no  investor  has  necessarily 
ever  lost  a  single  dollar  through  the  purchase  of  bonds  on  their 
recommendation.  With  such  a  record,  is  it  any  wonder  that, 
when  such  a  bond  house  offers  a  block  of  bonds  for  sale,  accom- 
panied by  a  recommendation,  that  the  entire  issue  is  often  over- 
subscribed within  twenty-jfour  hours  of  the  opening  of  the 
books  ? 

The  profit  of  the  banking  house  may  take  one  of  two 
forms,  either  a  commission  on  the  sales  or  the  diiFerence 
between  the  price  at  which  it  buys  the  securities  and  the 
price  at  which  it  sells  them.  Commission  is  more  com- 
mon and  is  regarded  as  more  profitable.  The  amount 
of  commission  depends  altogether  on  the  size  and  repu- 
tation of  the  issue,  and  no  definite  statement  on  this 
point  can  well  be  made. 

The  question  frequently  comes  before  such  a  house, 
Do  you  absolutely  guarantee  the  securities  that  you 
offer  to  be  safe  investments?  Invariably  the  answer  is: 
No,  we  give  you  freely  the  benefit  of  our  experience  and 
of  our  best  judgment,  but  whatever  risk  is  involved  is 
jrours,  not  ours;  we  guarantee  nothing.     Nevertheless, 


2S8  CORPORATION  FINANCE 

it  is  a  well-known  fact  that  almost  all  houses  of  the  best 
character  will  protect  their  customers  in  case  of  loss  or 
risk.  In  the  first  place,  the  house  does  not  lose  interest 
in  the  security  as  soon  as  the  issue  has  been  sold.  It 
watches  the  future  career  of  the  issuing  corporation 
with  the  closest  attention  and  frequently  exerts  strong 
influence  toward  a  conservative  management  of  the  cor- 
poration. If  in  spite  of  all  its  care  and  its  efforts,  the 
security  depreciates  in  value,  as  will  happen  once  in  a 
long  time,  the  house  will  probably  offer  to  buy  it  back 
from  its  customers  at  the  selling  price.  This  is  not  laid 
down  as  an  infallible  rule,  but  as  a  custom.  Of  course, 
the  house  does  not  feel  bound  to  follow  that  course  un- 
less it  has  very  strongly  recommended  the  security  in 
the  first  place.  Its  motive  in  making  the  offer  is  simply 
to  maintain  its  hard-won  reputation  for  fair  deahng. 


CHAPTER  XVII 

SELLING   SECURITIES— THE   WALL  STREET  MARKET 

125.  The  principal  stock  exchanges  of  the  United 
States, — The  stock  exchange  offers  the  best  market 
for  a  great  many  corporate  securities.  Some  readers 
are  perhaps  already  famihar  with  the  organization  of 
that  market  and  its  manner  of  conducting  business  and 
will  find  much  of  the  information  given  in  this  chapter 
already  familiar.  In  spite  of  the  importance  of  the 
Wall  Street  stock  exchange,  however,  and  in  spite  of 
the  glib  manner  in  which  almost  every  one  talks  about 
it  and  against  it,  surprisingly  few  people  have  a  correct 
understanding  of  its  operations. 

What  is  said  about  the  New  York  Stock  Exchange 
and  Wall  Street  in  this  chapter  applies  in  general,  with 
slight  modifications,  to  a  considerable  number  of  smaller 
stock  exchanges  in  the  larger  cities  of  the  United 
States.     Chief  among  these  exchanges  are: 

(1)  The  Boston  Stock  Exchange,  on  which  local 
securities  are  bought  and  sold  and  which  is  the  chief 
market  for  the  stocks  of  copper-mining  companies. 

(2)  The  Philadelphia  Stock  Exchange,  on  which 
local  securities  and  the  securities  of  the  Lehigh  Valley, 
the  Pennsylvania  and  the  Reading  Railroads  are  bought 
and  sold. 

(3)  The  Pittsburg  Stock  Exchange,  the  principal 
business  of  which  is  the  handling  of  securities  of  the 
local  steel  companies,  and  of  the  United  States  Steel 
Corporation. 

^39 


^40  CORPORATION  FINANCE  , 

(4)  There  are  stock  exchanges  also  in  Baltimore,  St. 
Louis,  Chicago  and  San  Francisco,  all  of  which  are 
comparatively  small  and  the  operations  of  which  are 
confined  to  local  securities. 

(5)  In  this  group  should  be  included  the  Consolidated 
Stock  Exchange  of  New  York,  or  the  "Little  Ex- 
change," as  it  is  frequently  termed,  whose  members  buy 
and  sell  the  same  stocks  that  are  traded  in  on  the  New 
York  Stock  Exchange,  or  "Big  Exchange."  The 
transactions  on  the  Consolidated  are  on  a  much  smaller 
scale  than  on  the  "Big  Exchange";  stocks  are  custom- 
arily bought  and  sold  in  ten  share  lots  or  multiples  of 
ten,  instead  of  in  one  hundred  share  lots  or  multiples  of 
one  hundred,  as  on  the  New  York  Stock  Exchange. 

The  reader  will  see  from  this  brief  summary  that 
large  dealings  in  securities  of  corporations  of  national 
importance  are  confined  almost  wholly  to  the  floor  of 
the  New  York  Stock  Exchange.  With  few  excep- 
tions the  stock  of  any  corporation  will  be  bought  and 
sold  on  one  exchange  and  one  only ;  the  chief  exceptions, 
to  most  of  which  allusion  has  already  been  made,  are: 
Amalgamated  Copper  Company  stock,  which  is  handled 
both  in  New  York  and  in  Boston;  Pennsylvania  Rail- 
road Company,  Lehigh  Valley  Railroad  Company,  and 
Reading  Railroad  Company,  both  in  New  York  and  in 
Philadelphia;  United  State  Steel  securities,  both  in 
New  York  and  in  Pittsburg. 

126.  Listing  securities, — In  the  first  paragraph  it 
was  stated  that  the  stock  exchanges  offer  an  excellent 
market  for  the  sale  of  securities  of  certain  corporations 
only.  This  limitation  must  be  stated,  because  each  of  the 
exchanges  confines  its  members,  so  far  as  trades  on  the 
floor  are  concerned,  to  a  comparatively  small  number  of 


I 


THE  WALL  STREET  MARKET  ^41 

approved  securities.  On  the  New  York  Stock  Ex- 
change these  approved  securities  fall  into  two  groups, 
the  "listed"  and  the  "unlisted."  The  exchange  has 
strict  rules  governing  the  admission  of  securities  to  the 
'listed"  group.  There  is  a  committee  of  five  to  whom 
are  referred  all  applications  for  including  securities 
among  those  listed.  Accompanying  the  application, 
there  must  be  filed  a  complete  description  of  the  prop- 
erty of  the  corporation,  a  full  and  true  balance  sheet, 
an  income  account,  and  information  on  certain  other 
points.  In  the  case  of  bonds  a  full  statement  of  the 
terms  under  which  the  bonds  are  issued,  a  certified  copy 
of  the  mortgage,  and  proof  that  the  mortgage  has  been 
properly  recorded,  must  be  submitted.  The  exchange 
strongly  recommends — a  recommendation  that  has  all 
the  force  of  an  order — that  corporations  whose  securi- 
ties are  listed  shall  furnish  to  their  stockholders  complete 
annual  reports  at  least  fifteen  days  prior  to  annual 
meetings. 

Many  industrial  corporations,  which  are  unwilling  to 
comply  with  the  requirements  as  to  publicity,  have  been 
admitted  to  the  unlisted  department.  This  means  that 
their  securities  are  bought  and  sold  on  the  floor  of  the 
exchange  in  the  same  manner  as  the  listed  securities, 
and  so  far  as  the  general  pubhc  is  concerned  there  is 
no  apparent  difference  between  the  two  classes.  There 
is,  in  fact,  however,  a  very  important  difference,  for 
the  corporations  whose  securities  are  unlisted  are  not 
required  to  give  complete  reports  as  to  their  opera- 
tions to  the  stock  exchange  conmiittee  or  to  their 
stockholders.  Although  the  public  do  not  appreciate 
the  fact  that  such  a  distinction  exists,  men  in  the  financial 
district  are  fully  alive  to  its  importance.     Listed  se- 

1—16 


M2  CORPORATION  FINANCE 

curities  are  almost  without  exception  much  more  highly 
regarded  by  bankers  and  are  more  acceptable  as  col- 
lateral for  bank  loans. 

For  this  reason,  most  corporations  prefer  to  comply 
with  the  requirements  and  have  their  securities  listed. 
About  85  per  cent  of  the  securities  handled  on  the  New 
York  Exchange  are  in  the  listed  department,  and  the 
unlisted  group — partly  on  account  of  the  force  of  the 
growing  demand  for  publicity — is  rapidly  declining  in 
numbers  and  in  importance.  Among  the  latest  converts 
from  the  unlisted  to  the  listed  class  are  two  industrial 
companies  of  great  size  and  importance,  the  American 
Sugar  Refining  Company  and  the  American  Smelting 
and  Refining  Company.  The  day  is  not  far  distant, 
we  may  hope,  when  practically  all  the  large  corporations 
will  willingly  carry  on  their  business  in  the  open  and 
meet  the  requirements  that  are  necessary  in  order  to 
have  their  securities  listed. 

127.  The  Curb  Market, — There  are  a  considerable 
number  of  large  corporations  that  are  unwilling  or 
unable  to  furnish  even  the  very  moderate  amount  of 
information  that  is  necessary  in  order  to  have  their 
securities  placed  in  the  unlisted  department.  There  are 
other  securities  that  are  very  highly  speculative  in  their 
nature,  or  that  are  issued  by  corporations  which  are  not 
honestly  and  efficiently  managed — "cats  and  dogs" 
such  securities  are  called  in  Wall  Street  slang — which 
are  bought  and  sold  in  considerable  quantities  in  the 
Wall  Street  district.  As  svich  securities  would  not  be 
admissible  under  the  rules  of  any  reputable  exchange, 
an  outside  unorganized  market  has  come  into  existence. 
This  is  known  as  the  Curb  Market,  for  the  reason  that 
the  meetings  of  the  brokers  who  participate  in  it  are  held 
in  the  open  air  in  one  of  the  streets  in  the  Wall  Street 


THE  WALL  STREET  MARKET  243 

district  near  the  street  curb.  There  are  no  written  rules 
and  no  fixed  organization  for  the  Curb  Market.  Any- 
one may  go  among  the  throng  of  brokers  standing  on  the 
street  and  buy  or  sell  securities  if  he  can  find  anyone 
else  to  trade  with  him.  As  a  matter  of  fact,  however, 
a  stranger  would  not  be  able  to  transact  any  business, 
for  no  one  would  be  sure  that  he  would  live  up  to  what- 
ever obligations  he  might  contract.  In  practice,  in 
order  to  do  business  on  the  "Curb,"  a  broker  must  either 
have  high  standing  and  reputation  on  his  own  account 
or  must  be  a  representative  of  an  established  brokerage 
firm.  Among  the  well-known  and  important  corpora- 
tions whose  securities  are  bought  and  sold  in  the  Curb 
Market  we  may  mention  the  Standard  Oil  Company,  the 
American  Tobacco  Company  common  stock,  and  the 
Chicago  Subway  Company.  Most  of  the  other  active 
stocks  on  the  Curb  Market  are  of  mining  companies. 
There  are  also  some  large  bond  issues  which,  for  one 
reason  or  another,  are  not  listed  on  the  stock  exchange, 
including  Chicago,  Burlington  and  Quincy  4's,  National 
Railway  of  Mexico  4l/^'s,  and  Western  Pacific  5's.  The 
Curb  Market  is  also  the  center  of  transactions  in  "rights" 
(which  are  described  in  Chapter  XXVII)  and  in 
contracts  for  purchase  and  delivery  of  stock  and  bonds 
that  are  not  yet  issued.  Such  stocks  and  bonds  are 
traded  in  "w.  i.,"  to  use  the  Wall  Street  abbreviation, 
which  stands  for  "when  issued." 

128.  Stock  Eoochange  methods. — The  scene  on  the 
floor  of  any  of  the  regular  stock  exchanges  and  on  the 
street  where  the  curb  brokers  congregate  always  seems 
to  an  uninitiated  observer  strange  and  confusing.  On 
the  larger  exchanges  he  sees  a  number  of  posts  set  up 
at  regular  intervals,  each  post  bearing  the  initials  of 
several  of  the  corporations  whose  securities  are  listed  on 


^44  CORPORATION  FINANCE 

that  particular  exchange.  Around  each  post,  if  it  is  a 
busy  day,  are  a  large  number  of  brokers,  each  armed 
with  a  pencil  and  a  memorandum  pad,  and  many  of 
them  engaged  in  making  frantic  signs  to  other  brokers. 
The  signs,  which  are  unintelligible  to  the  outsider,  in- 
dicate offers  to  buy  at  a  certain  price  or  acceptances. 

A  broker  who  has  the  stock  or  bonds  of  any  corpora- 
tion to  sell  goes  to  the  post  to  which  that  corporation 
is  assigned,  offers  his  stock  and  receives  bids.  Any 
reader  who  has  never  visited  an  exchange  must  not  get 
the  idea  that  this  proceeding  is  as  simple  and  unexciting 
as  it  seems  when  described  in  cold  print.  If  the  market 
is  at  all  active,  the  seller  may  have  to  fight  his  way  to 
the  center  of  a  struggling  group,  yell  out  his  offer  at 
the  top  of  his  voice,  and  accept  one  or  more  of  the  bids 
that  may  be  yelled  back  at  him  in  the  twinkling  of  an 
eye.  The  noise  that  comes  from  the  floor  of  a  crowded 
stock  exchange  during  an  active  business  day  resembles 
nothing  so  much  as  the  roaring  of  wild  beasts. 

It  has  often  been  remarked,  as  an  indication  of  the 
•good  faith  and  high  standards  of  honor  that  must  pre- 
vail as  a  rule  among  stock-exchange  brokers,  that  in  the 
midst  of  all  this  confusion  and  outcry  a  hasty  sign  from 
the  purchaser  and  a  nod  from  the  seller  of  a  block  of 
securities  may  close  a  deal  involving  thousands  of 
dollars.  Each  broker  makes  his  own  memorandum  of 
the  transaction  and  at  the  close  of  the  day  the  houses 
which  they  represent  compare  notes  and  through  the 
stock  exchange  clearing  house  settle  their  balances.  It 
is  very  seldom  that  a  serious  error  or  even  a  misunder- 
standing occurs.  Differences  of  opinion  as  to  prices 
and  quantities  of  securities  are,  of  course,  inevitable 
once  in  a  while,  but  are  usually  adjusted  in  the  friendliest 
manner. 


THE  WALL  STREET  MARKET  245 

The  volume  of  business  transacted  in  this  manner  on 
the  leading  stock  exchanges  is  enormous.  Million 
share  days  on  the  New  York  Stock  Exchange,  though 
somewhat  above  the  average,  are  not  at  all  uncommon. 
In  other  words,  $100,000,000  worth  of  business  is  trans- 
acted. Of  course  it  goes  without  saying  that  such 
quantities  of  shares  are  not  bought  outright,  taken  out 
of  the  market  and  placed  in  a  vault.  On  the  contrary, 
the  great  mass  of  the  business  of  buying  and  selling  is 
speculative.  What  is  actually  bought  and  sold  is  the 
right  to  receive  or  the  right  to  deliver  certain  quantities 
of  shares  at  the  end  of  the  day  at  the  price  fixed  in  the 
deals  between  brokers.  In  most  cases  no  actual  delivery 
is  made.  Through  the  stock  exchange  clearing  house 
the  transactions  in  the  same  stock  offset  each  other  and 
only  the  balances  are  delivered  by  those  who  sold  to  those 
who  buy.  Many  floor  traders  seldom  see  any  stock 
certificates  because  they  make  it  a  rule  to  sell  during  the 
day  as  much  as  they  buy.  They  make  both  sales  and 
purchases  with  the  view  to  "scalping"  small  profits,  % 
and  14  P^r  cents. 

129.  Importance  of  speculative  dealings, — Nothing 
need  be  said  here  as  to  the  ethics  of  speculation,  a  subject 
which  is  adequately  treated  in  another  volume.  It  may 
be  well  to  remark,  however,  that  all  these  speculative 
transactions  on  the  stock  exchange,  particularly  the 
small  transactions,  perform  at  least  one  very  useful 
service,  namely,  they  tend  to  steady  security  prices. 
Obviously,  if  a  stock  starts  to  move  up  or  down  and  a 
group  of  floor  traders  are  at  hand  all  trying  to  sell  at 
each  slight  advance  with  a  view  to  getting  their  small 
speculative  profits,  the  price  will  probably  not  soar  very 
rapidly.  The  same  remark  in  substance  wiU  apply  to 
all  speculative  dealings. 


Ue  CORPORATION  FINANCE 

Enough  has  been  said  about  the  stock  exchanges  and 
stock  and  bond  brokers  to  give  some  idea  perhaps  of 
their  methods  of  operation.  It  is  no  part  of  the  business 
of  stockbrokers  to  buy  and  sell  to  any  large  extent  on 
their  own  account,  although  many  of  them,  to  be  sure, 
do  not  by  any  means  abstain  from  so  doing.  Their 
main  function,  however,  is  to  serve  as  agents  for  other 
persons  who  may  desire  to  buy  or  sell  securities.  Some 
of  these  persons  are  true  investors  who  are  either  parting 
with  some  of  their  stockholdings  for  cash  or  are  buying 
securities  outright  with  a  view  to  holding  them  for  the 
sake  of  dividends  and  of  future  increases  in  their  value. 
Such  persons,  however,  are  in  the  minority ;  most  of  the 
buying  and  selling  of  stocks  on  the  stock  exchanges  is 
speculative.  Of  this  speculative  business  a  small  pro- 
portion is  carried  on  by  the  outright  purchase  of  stocks 
or  bonds,  which  the  purchaser  hopes  will  rise  in  value 
within  a  short  time  so  that  he  may  sell  at  a  substantial 
profit;  or  by  the  outright  sale  of  securities  which  the 
seller  hopes  to  be  able  to  buy  back  within  a  short  time 
at  a  substantial  reduction.  The  great  mass  of  specula- 
tive business,  however,  and  for  that  matter  of  all  the 
business  transacted  in  Wall  Street,  consists  of  buying 
and  selling  "on  margin." 

130.  Buying  on  margin, — By  marginal  transactions 
are  meant  those  in  which  most  of  the  necessary  funds 
are  borrowed  and  only  a  small  percentage  or  "margin" 
is  required  of  the  person  for  whom  the  securities  are 
bought  or  sold.  The  procedure  in  making  a  marginal 
speculative  purchase  is  somewhat  as  follows:  The 
speculator  desires  to  own,  we  will  say,  one  hundred 
shares  of  a  stock  which  is  selling  at  or  near  a  par  of 
$100 ;  the  least  margin  that  will  be  accepted  by  reputable 


THE  WALL  STREET  MARKET  247 

brokers  in  such  a  case  will  be  $10  per  share.  The  specu- 
lator, therefore,  assuming  that  he  does  not  already  have 
an  account  with  his  broker,  gives  him  a  check  for  $1,000 
and  an  order  to  buy  the  one  hundred  shares.  A  repre- 
sentative of  the  brokerage  firm  buys  the  one  hundred 
shares  on  the  floor  of  the  exchange  in  the  manner  already 
described.  At  the  end  of  the  day  he  must  be  prepared 
to  pay  for  the  shares,  which  means  an  outlay  of  approxi- 
mately $10,000  (100  shares  at  $100  each).  In  order 
to  raise  this  amount  the  broker  arranges  with  his  bank 
to  accept  the  shares,  after  they  are  bought,  as  collateral 
for  a  loan,  which  on  standard  stocks  will  be  about  80 
per  cent  of  the  market  value,  or  on  this  block,  $8,000. 
There  still  remains  a  difference  of  $1,000  which  the 
broker  must  supply  out  of  his  own  funds.  If  the  stock 
shortly  after  this  transaction  advances,  we  will  say  ten 
points,  the  fortunate  speculator  will  perhaps  give  an 
order  to  sell,  and  the  broker  will  secure  approximately 
$11,000  for  the  block.  With  this  he  repays  the  bank 
loan  of  $8,000,  reimburses  himself  for  his  loan  of  $1,000 
and  after  deducting  interest  on  the  $9,000  supplied  by 
the  bank  and  by  himself  and  deducting  his  brokerage 
charges,  he  turns  the  rest  over  to  the  speculator.  On 
the  other  hand,  if  the  stock  goes  down  seven  or  eight 
points  the  speculator  is  called  upon  to  put  up  additional 
margin  or,  failing  that,  the  broker  sells  the  stock,  repays 
the  bank  loan,  reimburses  himself,  deducts  interest  and 
brokerage  charges  as  before,  and  returns  to  the  specu- 
lator anything  that  may  happen  to  be  left  of  his  $1,000. 
131.  Selling  short. — If  the  speculator  chooses  to  sell 
on  margin,  or  "selL  short"  in  the  Wall  Street  phrase,  he 
deposits  his  $1,000  as  before  and  orders  the  broker  to 
sell.     The  broker's  representative  executes  the  sale  on 


248  CORPORATION  FINANCE 

the  floor  of  the  exchange  and  of  course  is  called 
upon  to  make  delivery  at  the  end  of  the  day.  As 
neither  the  speculator  nor  the  broker  owns  the  stock  that 
has  been  sold,  it  is  necessary  for  the  broker  to  borrow 
the  stock  from  some  owner.  This  he  does  in  the  "loan 
corner,"  as  it  is  called,  of  the  stock  exchange,  where 
stocks  are  loaned  to  "shorts"  on  payment  of  the  market 
price.  In  form  this  loan  is  a  sale  of  stock ;  it  is  provided, 
however,  that  on  return  of  the  stock  the  amount  paid 
for  the  stock  will  be  given  back.  This  borrowed  stock 
the  broker  uses  to  make  delivery  of  the  block  that  he  has 
sold.  If  within  a  short  time  the  stock  goes  down,  the 
fortunate  speculator  orders  his  broker  to  buy  a  block 
at  the  lower  price ;  the  broker  uses  the  block  that  he  buys 
to  repay  the  lender  of  the  stock  with  which  delivery  was 
originally  made.  He  turns  over  to  the  speculator  his 
$1,000  margin  plus  the  difference  between  the  price  at 
which  the  block  of  stock  was  sold  and  the  price  at  which 
it  was  bought  and  minus  brokerage  charges.  Credit 
will  be  allowed  to  the  speculator  also  in  this  case  for 
whatever  dividends  may  have  accrued  on  the  borrowed 
block  of  stock  while  in  the  hands  of  the  broker.  On  the 
other  hand,  if  the  stock  goes  up  several  points  in  this 
case,  the  broker  will  call  for  more  margin;  failing  that, 
he  will  buy  a  block  of  stock  with  which  to  repay  the  stocl 
he  has  borrowed,  will  deduct  from  the  speculator's 
margin  the  difference  between  the  price  at  which  the 
stock  was  sold  and  the  price  at  which  it  was  bought,  toi 
gether  with  interest  and  brokerage  charges,  crediting  the 
stockholder  with  any  dividends  that  may  have  accruec 
on  the  stock  while  in  his  hands,  and  will  then  return  t( 
the  speculator  anything  that  may  be  left  of  his  $1,000J 
132.  Stock  exchange  houses  vs,  bucket  shops. — The 
following  quotation  from  a  circular  letter  issued  by 


THE  WALL  STREET  MARKET  249 

large  brokerage  house  gives  an  accurate  statement  of 
the  terms  upon  which  reputable  brokers  handle  marginal 
transactions : 

We  execute  commission  orders  for  the  outright  purchase,  in 
any  amount,  of  hsted  stocks.  Our  charge  is  that  fixed  for  all 
members  of  the  New  York  Stock  Exchange,  %  of  1  per  cent 
of  the  par  value,  or  12%  cents  a  share,  except  that  we  make  a 
minimum  charge  of  $1  for  any  one  transaction. 

Our  requirement  for  doing  business  upon  margin  is  10  per  cent 
upon  the  par  value  of  the  active  Stock  Exchange  issues  quoted 
at  50  or  below ;  15  per  cent  for  those  quoted  between  50  and  100 ; 
and  20  per  cent  for  those  quoted  above  100.  We  reserve  the 
right,  when  opening  a  margin  account,  to  refuse  to  purchase 
those  securities  which  either  have  not  a  ready  market  or  are  not 
available  for  collateral  purposes.  Those  who  desire  to  sell  active 
stocks  short,  may  do  so  upon  a  maintained  margin  of  15  per 
cent,  in  the  case  of  stocks  selling  at  par  or  below,  and  upon  a 
margin  of  20  per  cent  in  the  case  of  those  selling  above  par,  we, 
of  course,  to  reserve  the  right  to  discriminate  against  any  partic- 
ular securities. 

We  do  not  buy  or  sell  less  than  100  shares  of  stock  or 
$10,000  of  bonds,  upon  margin,  so  that  $1,000  is  the  least 
amount  with  which  such  an  account  can  be  opened.  Our  in- 
terest charges  depend  upon  the  cost  of  our  own  funds  and  are 
figured  at  the  end  of  each  month,  so  we  cannot  say  In  advance 
just  what  rate  will  be  charged,  but  we  will  be  glad  to  take  this 
question  up  in  detail  at  any  time. 

In  opening  margin  accounts  we  require  either  a  bank  refer- 
ence or  an  introduction  from  some  of  our  friends. 

We  never  open  margin  accounts  for  women  or  in  the  name 
of  a  woman,  nor  do  we  open  margin  accounts  for  bank  officials 
or  bank  employees. 

Just  a  word  should  be  said  here  about  bucket  shops 
and  swindling  brokerage  concerns  of  all  kinds.  The 
characteristic  of  all  such   concerns   is   that  whatever 


250  CORPORATION  FINANCE 

money  is  turned  over  to  them  for  buying  and  selling 
stocks  never  gets  out  of  their  own  pockets.  Whatever 
may  be  said  as  to  the  ethics  of  true  stock  exchange 
speculation,  and  as  to  its  moral  and  economic  effects, 
it  is  certainly  true  that  Wall  Street  ought  not  to  be 
blamed  for  the  existence  of  the  methods  of  the  bucket 
shops.  Wall  Street  brokers  are,  as  a  rule,  entirely 
honorable  in  their  dealings  with  customers.  They  make 
it  their  business  to  execute  whatever  orders  are  given 
to  them  by  their  customers  under  conditions  which  are 
fully  and  clearly  set  forth.  If  the  customer  misunder- 
stands those  conditions  or  misjudges  the  market,  it  is 
his  own  fault,  not  the  broker's.  A  legitimate  broker 
will  make  every  effort  to  guide  his  customer  aright  and 
protect  him  from  loss,  for  the  broker's  reputation  and 
success  depend  directly  on  the  success  of  his  customers. 
The  bucket  shop,  on  the  other  hand,  obviously  prospers 
from  the  losses  of  its  customers. 

133.  The  classes  of  Wall  Street  speculators. — The 
Wall  Street  speculative  contingent  may  roughly  be  di- 
vided into  three  classes:  first.  Wall  Street  men,  bank- 
ers, brokers  or  corporation  officials,  who  buy  and  sell 
securities  on  a  large  scale  and  who  make  it  their  business 
to  keep  in  constant  touch  with  all  that  goes  on  in  the 
stock  market;  second,  substantial  men  of  property  and 
business  standing  whose  first  interests  are  not  in  the 
Wall  Street  game,  but  who  take  a  "flier"  once  in  a  while 
in  some  security  or  group  of  securities  of  which  they 
have  special  knowledge;  third,  the  hangers-on,  the  true 
lambs,  a  class  made  up  largely  of  professional  men, 
broken-down  business  men  and  women,  who  are  suffer- 
ing under  the  delusion  that  they  can  make  money  in^ 
Wall  Street  without  having  a  special  knowledge  eithe] 
of  Wall  Street  methods  or  of  th^  conditions  in  some  par- 


THE  WALL  STREET  MARKET    •  251 

ticular  line  of  industry.  This  third  class  is  by  no  means 
so  large  as  the  moralists,  the  muck-rakers  and  the  comic 
papers  represent;  yet  it  is  true  that  its  representatives 
are  only  too  painfully  in  evidence.  It  is  true  also  that 
the  members  of  this  class  inevitably  lose  in  the  long  run, 
and  that  too  often  they  are  infected  with  a  poison  that 
ruins  them  both  financially  and  morally.  It  is  more 
than  doubtful,  however,  if  Wall  Street  ought  to  be  held 
responsible  for  the  losses  of  such  people.  For  the  most 
part  they  are  weak  and  foolish  and  it  may  safely  be  said 
that  if  they  had  not  fallen  victims  to  the  Wall  Street 
craze  they  would  have  found  some  other  means  of  losing 
their  money. 

134.  A  summary  view  of  the  stock  market, — What 
precedes  is  intended  to  present  to  the  reader  a  bird's- 
eye  view  of  the  Wall  Street  market,  or  the  stock  ex- 
change market,  for  securities.  To  recapitulate:  only  a 
comparatively  few  large  corporations  have  their  secur- 
ities listed  on  any  of  the  stock  exchanges ;  those  corpora- 
tions whose  securities  are  listed  have  a  well-advertised, 
continuous  and  easily  accessible  market  for  their  secur- 
ities; this  market  is  utilized  both  by  investors  and  by 
speculators,  but,  so  far  as  stocks  are  concerned,  the  specu- 
lative element  is  of  chief  importance;  most  of  the 
speculation  is  carried  on  by  means  of  marginal  purchases 
and  sales;  the  speculators  may  be  classified  under  the 
three  heads.  Wall  Street  operators,  business  men  and 
"lambs."  With  these  leading  facts  before  us,  we  are 
now  ready  to  discuss  briefly  the  process  of  selling  a  new 
security  through  the  stock  exchange  markets. 

135.  Stimulating  speculative  interest, — If  the  new 
security  is  a  small  issue  put  out  by  one  of  the  less  im- 
portant companies,  the  process  of  selling  it  through  a 
stock  exchange  will  not  be  much  different  from  that 


252  CORPORATION  FINANCE 

which  has  been  described  in  previous  chapters.  The 
new  security  will  be  advertised,  inquiries  wiU  be  invited, 
an  alluring  prospectus  will  be  issued,  the  new  security 
will  be  listed  and  the  corporation  managers  will  then  sit 
back  and  wait  for  orders  to  reach  them. 

Let  us  suppose,  however,  that  a  new  stock  of  a  large 
issue  is  to  be  put  out  by  one  of  the  well-known  com- 
panies. In  that  case,  the  corporation  managers,  or  the 
syndicate  which  is  underwriting  and  handling  the  sale 
of  that  stock,  will  not  only  take  all  the  means  mentioned 
in  the  preceding  paragraph  to  insure  the  success  of  the 
sale,  but  will  go  further.  They  will  take  measures  to 
create  a  speculative  interest  in  the  stock  and  to  "make  a 
market"  at  a  good  price. 

In  addition  to  their  advertisements  and  prospectuses, 
they  will  probably  set  to  work  other  forces  still  better 
jBtted  to  secure  buying  orders  from  marginal  specula- 
tors. Now  the  average  speculator  is  not  much  attracted 
by  brass  band  announcements  or  even  by  newspaper 
stories,  no  matter  how  well  written  and  convincing  they 
may  seem.  But  he  rises  to  a  tip  like  a  himgry  fish  to 
the  bait.  He  reasons  that  what  is  known  to  everybody 
will  bring  little  profit  to  himself,  but  that  information 
which  comes  to  him  confidentially  by  word  of  mouth 
gives  him  an  exceptional  opportunity.  Therefore,  Wall 
Street,  from  morning  to  night  in  an  active  market,  hums 
with  tips,  rumors  and  gossip.  The  tips  that  are  thus 
circulated  are  not  aU  valueless  by  any  means,  although  it 
must  be  admitted  that  a  speculator  who  follows  them  too 
closely  will  probably  be  a  heavy  loser  in  the  end.  The 
first  move,  then,  of  the  managers  of  a  large  new  stock 
issue  will  probably  be  to  see  to  it  that  rumors  as  to  the 
extent  and  high  quality  of  the  issue,  and  above  all,  as  to 
the  "interests"  that  will  support  its  market  price,  begin 


4 


THE  WALL  STREET  MARKET 

to  circulate.  Thus  the  appetite  of  speculators  will  be 
stimulated  and  large  buying  orders  from  them  will  prob- 
ably await  the  first  appearance  of  the  stock  on  the 
market. 

The  next  step  will  be  to  range  the  brokers  in  favor  of 
the  new  issue,  so  that  whatever  advice  they  give  to  their 
customers  will  tend  to  favor  its  purchase.  The  most  di- 
rect method  of  securing  the  brokers'  favorable  attention 
is  by  seeing  to  it  that  the  new  stock  is  acceptable  as  col- 
lateral for  bank  loans.  Partly  for  this  reason  it  is  very 
important  that  among  the  persons  interested  from  the 
beginning  in  the  new  issue  should  be  representatives  of 
large  banking  interests.  If  the  broker  feels  sure  that 
the  stock  will  be  acceptable  as  collateral,  he  knows  that 
he  will  be  able  to  carry  large  amounts  of  it  for  his  cus- 
tomers on  easy  terms. 

136.  Syndicate  operations, — The  next  step  is  to  se- 
cure an  agreement  among  the  syndicate  members  and 
perhaps  with  large  banking  and  brokerage  interests  out- 
side the  syndicate  that  the  price  of  that  particular  se- 
curity will  be  held  at  a  given  figure.  Thus  when  the 
Interborough-Metropolitan  Company,  the  great  $240,- 
000,000  merger  of  the  transportation  lines  of  New  York 
City,  was  formed,  the  members  of  the  syndicate  were 
said  to  have  agreed  that  the  price  of  the  common  stock 
should  not  be  allowed  to  fall  below  fifty.  In  order  to 
maintain  the  price  at  this  point  they  were  compelled 
after  the  stock  had  been  issued  to  purchase  large  blocks 
and  take  them  off  the  market.  In  this  particular  case 
the  syndicate,  for  reasons  which  need  not  be  here  dis- 
cussed, went  to  pieces  after  about  a  year,  and  the  price 
of  the  common  stock  suddenly  broke  very  sharply. 
During  the  year,  however,  the  agreement  was  lived  up 
to.     Where  such  an  agreement  is  made  and  maintained, 


^54  CORPORATION  FINANCE 

the  effect  is  to  steady  the  price  of  the  stock,  or  at  least 
to  hold  it  above  the  figure  agreed  upon,  and  thereby  to 
attract  both  speculators  and  investors. 

137.  Stock  market  manipulation,' — The  fourth  step 
in  making  a  market  for  a  new  issue  is  to  manipulate  the 
price  in  such  a  manner  as  to  gain  the  good  will  of  specu- 
lators and  brokers  and  arouse  expectations  of  large 
profits.  Manipulating  a  stock  is  a  process  that  requires 
great  skill,  judgment  and  cool  nerve.  Several  men 
in  the  Wall  Street  district  have  become  famous  for  their 
abilities  along  this  line;  foremost  among  them  is  the 
well-known  and  successful  operator,  James  R.  Keene. 
To  Mr.  Keene  have  been  entrusted  most  of  the  large 
speculative  stock  flotations  of  recent  years.  He  has 
been  almost  uniformly  successful. 

One  method  by  which  a  manipulator  may  fix  a  quota- 
tion for  his  security  is  by  "wash  sales,"  by  which  is  meant 
selling  with  one  hand  and  buying  with  the  other. 
Brokers  on  the  New  York  Stock  Exchange,  according 
to  the  rules  of  the  exchange,  are  not  allowed  to  be 
parties  knowingly  to  such  a  process.  They  are  not  sup- 
posed to  know,  however,  and  as  a  matter  of  fact,  cannot 
know,  whether  or  not  a  selling  order  given  to  them  is 
matched  by  a  buying  order  simultaneously  given  to  an- 
other broker.  By  means  of  such  matched  orders  a  ma- 
nipulator may  raise  or  depress  the  price  of  a  stock  al- 
most at  will  with  no  further  expense  than  brokerage 
commissions — provided,  of  course,  that  his  plans  are  not 
interfered  with  by  large  buying  or  selling  orders  from 
other  parties.  It  is  customary  for  a  stock  market  ma- 
nipulator in  this  manner  to  fix  or  attempt  to  fix  the  price 
of  a  security  at  the  beginning  and  then  gradually  raise 
its  price  and  thus  stimulate  speculative  interest  in  the 
security. 


THE  WALL  STREET  MARKET  255 

As  the  security  advances  in  price  and  stockholders 
begin  to  send  in  their  orders  to  buy,  the  manipulator,  if 
his  plans  work  out  successfully,  gradually  feeds  out 
small  amounts  of  the  stock  that  he  has  on  hand.  This 
process  must  be  very  gradual  and  carried  on  in  such  a 
manner  that  it  cannot  easily  be  observed;  otherwise,  the 
stock-market  price  will  be  depressed,  stockholders  will 
take  warning  and  will  begin  to  sell  and  the  market  will 
be  spoiled.  Furthermore,  it  is  not  well  to  allow  the  price 
to  go  up  too  rapidly  or  too  steadily;  otherwise  the  ma- 
nipulation will  be  too  apparent  and  furthermore  no  op- 
portunity will  be  given  to  prospective  buyers  to  purchase 
at  slight  recessions  from  previous  prices.  The  price  of 
a  skillfully  manipulated  stock  will  move  upward  and 
downward  by  jerks,  the  tendency  on  the  whole  being  up- 
ward. If  the  manipulation  is  secret  and  skillful,  not 
even  the  most  expert  observer  can  be  certain  whether  the 
price  is  subject  to  manipulation  or  not. 

It  will  be  impossible  here  to  enter  into  a  study  of  all 
the  intricacies  of  manipulation  and  of  the  schemes  which 
have  been  successfully  worked  in  the  past.  The  object 
of  this  chapter  is  attained  if  the  reader  sees  that  the  se- 
curities, stocks  especially,  of  large  corporations  may  be 
sold  through  the  stock  market  at  much  higher  prices 
than  would  be  possible  if  the  same  stocks  were  sold  direct 
to  investors.  A  further  study  of  this  interesting  branch 
of  our  subject  will  be  found  in  the  volume  on  Invest- 
ment AND  Speculation. 


CHAPTER  XVIII 

SELLING    SECURITIES— THE    UNDERWRITING 
SYNDICATE 

138.  Origin  of  underwriting, — One  means  of  float- 
ing an  issue  of  securities,  we  have  seen,  is  to  dispose  of 
them  through  the  agency  of  banking  and  brokerage 
houses.  In  such  cases  the  financial  houses  may  not 
merely  undertake  to  sell  the  securities,  but  may  make 
themselves  responsible  for  the  success  of  the  sale.  One 
method  of  so  doing  is  by  agreeing  to  take  for  them- 
selves, if  no  other  purchasers  are  found  within  a  specified 
period,  all  of  the  unsold  portion  of  the  issue  at  a  certain 
agreed  price.  Thus  the  issuing  corporation  is  reheved 
of  part  of  its  risk  and  the  buyers  of  the  securities  are 
made  to  feel  that  well-informed  financiers  have  faith  in 
their  value.  This  process — modified  more  or  less,  as 
described  later  in  this  chapter — is  known  as  under- 
writing. 

The  origin  of  underwriting  is  to  be  found  in  the 
famous  London  institution  called  Lloyd's.  Lloyd's 
Coffee  House  was  the  place  where  the  export  and  import 
merchants  of  London  assembled  two  hundred  years  ago 
to  transact  their  business  with  shippers.  As  all  such 
trade  at  that  time  was  peculiarly  subject  to  mishaps  of 
all  kinds,  the  practice  grew  up  of  dividing  the  risk  on 
cargoes  and  shipments  among  a  large  number  of  mei 
chants;  each  party  to  the  agreement  wrote  his  nam( 
under  the  contract  and  from  this  custom  arose  the  name 
"underwriting."    We  are  to  discuss  in  this  chapter  the 

^56 


THE  UNDERWRITING  SYNDICATE  25T 

same  principle  as  it  is  now  applied  to  new  issues  of  se- 
curities. The  essential  part  of  the  arrangement  is  the 
insuring^  of  someone  against  loss  or  failure.  A  secon- 
dary feature  is  the  ^ivisjon  of  the  risk  among  a  con- 
siderable number  of  people,  so  that  no  one  of  the  in- 
surers is  liable  to  suffer  great  loss. 

139.  Advantages  of  underwriting  to  the  corporation, 
— There  are  several  reasons  why  banking  and  brokerage 
houses  may  properly  carry  on  this  business  of  financial 
underwriting  and  why  the  business  is  usually  profitable 
both  to  themselves  and  to  the  corporation  which  issues 
the  underwritten  securities.  In  the  first  place,  the 
bankers^e  presumably^jperts  in  the  valuation  of  se- 
curities. Their  judgment  as  to  the  price  which  should 
be  set  on  a  new  security  or  as  to  the  terms  of  exchange, 
if  the  new  security  results  from  a  conversion  of  an  old 
security,  is  a  valuable,  authoritative  judgment.  In  the 
second  place,  the  bankers  are  also  experts  in  selling  se- 
curities and  each  house  involved  in  the  underwriting 
usually  has  an  established  clientele  to  whom  it  may 
readily  dispose  of  almost  any  securities  that  it  recom- 
mends. The  corporation,  on  the  other  hand,  has  no 
facilities  whatever  for  selling  stocks  and  bonds;  its  ac- 
tivities are  in  the  field  of  transportation,  or  industry,  or 
trade,  not  in  finance. 

Two  further  reasons  are  even  more  potent  in  inducing 
corporation  managers  to  have  new  security  issues  under- 
written. First,  even  though  the  corporation  can  obtain 
expert  financial  advice  and  is  reasonably  sure  to  make 
a  success  ultimately  of  the  sale  of  any  securities  it  puts 
out,  yet  the  time  that  will  elapse  before  the  sale  is  com- 
pleted and  the  money  received  is  always  uncertain. 
Now  the  corporation  ordinarily  v/ould  not  be  trying  to 
sell  new  securities  if  it  did  not  need  money  at  once  or  in 

1—17 


^58  CORPORATION  FINANCE 

the  near  future.  It  is  disastrous  to  the  success  of  many 
industrial  or  commercial  operations  to  hold  them  in 
abeyance  until  the  tedious  process  of  selHng  a  large  block 
of  bonds  or  stocks  is  completed;  yet  it  is  dangerous  to 
go  ahead  so  long  as  the  sale  is  incomplete.  This  delay 
can  be  avoided  by  having  the  security  uaderwritten, 
for  the  underwriters  will  pay  the  corporation  within  a 
definite  period.  The  second  reason  that  appeals 
strongly  to  corporation  managers  is  that  the  credit^f 
a  corporation  is  seriously  affected  by  any  apparent^  in- 
ability  to  market  its  securities.  One  failure — or  even  a 
success  that  is  too  hard-won — ^would  hamper  the  corpo- 
ration greatly  both  in  getting  loans  and  in  making 
future  sales  of  stock. 

140.  Advantage  to  the  buyers  of  securities, — There 
are  telling  advantages  to  the  buyers  of  securities  also  in 
having  them  underwritten.  As  was  pointed  out  in 
Chapter  XVI,  reputable  banking  houses  never  sell  se- 
curities until  after  they  have  been  satisfied  ^  a  search- 
ing investigation  that  the  securities  are  all  that  they  are 
represented  to  be.  Though  this  does  not  mean  a  guar- 
antee on  the  part  of  the  banking  house,  it  does  mean 
that  the  buyer  has  the  advantage  of  their  expert,  and 
presumably  impartial,  examination  of  every  question, 
legal,  financial,  accounting,  engineering  or  commercial, 
that  pertains  to  the  new  security.  This  investigation  is 
expensive;  no  ordinary  investor  could  afford  it  on  his 
own  account.  He  is,  therefore,  willing  to  pay  a  little 
higher  price  for  a  security  if  this  service  has  been  per- 
formed. 

Another  advantage  to  the  buyer  is  that  he  may  be  sure 
that  the  whole  security  issue  has  been  sold  by  the  cor- 
poration. A  half -sold  issue  is  a  sign  of  weakness  and  a 
hindrance  to  the  completion  of  the  corporation's  plans 


i 


THE  UNDERWRITING  SYNDICATE  259 

so  serious  as  to  reduce  the  value  usually  of  the  portion 
that  has  been  sold.  Suppose,  for  instance,  that  an  in- 
dustrial company  desires  to  build  a  new  plant  at  a  cost 
of  $10,000,000  and  sells  only  $8,000,000  worth  of  the 
securities  which  are  intended  to  finance  the  project. 
What  can  the  company  do?  It  can  neither  complete 
the  plant  nor  return  the  $8,000,000.  In  all  probability 
the  money  will  be  used  unprofitably  and  the  stocks  or 
bonds  sold  by  the  company  will  be  poorly  secured.  This 
danger  is  avoided  when  the  whole  block  of  securities  is 
taken  at  one  time  by  underwriters. 

A  third  advantage  to  the  buyer  is  that  any  reputable 
banking  house  will  watch  closely  any^  security  that  it  has 
underwritten,  and  will  come  to  the  assistance  of  tlie^ 
security-holders  in  case  the  corporation  later  gets  into 
difficulties.  As  will  be  brought  out  in  our  study  of  re- 
organization, the  committees  formed  to  assist  in  devising 
plans  to  reorganize  insolvent  corporations  almost  always 
contain  representatives  of  banking  houses  who  are  there 
to  look  after  the  interests  of  their  clients. 

For  these  reasons  janderwritmg  certainly  adds_to_the 
value  of  securities.  The  underwriters  naturally  are  not 
impelled  by  charitable  motives ;  they  expect  a  reasonable 
compensation  for  their  risk  and  trouble,  and  frequently 
the  compensation  runs  well  up  into  millions  of  dollars. 
Barring  collusion  and  graft,  which  have  been  only  too 
apparent  in  isolated  cases,  it  may  be  laid  down  as  a 
general  rule,  however,  that  the  underwriters  give  more 
than  value  received.  There  is  no  question  in  the  writer's 
mind  but  that  our  corporation  financing  is  cleaner  and 
more  efficient  because  underwriting  is  the  general  prac- 
tice. It  is  hard  to  over-estimate  the  value  of  examina- 
tion and  supervision  by  fair-minded  financial  experts. 

141.  When  is  underwriting  advisable? — It  must  not 


^60  CORPORATION  FINANCE 

be  inferred  that  every  new  stock  or  bond  issue  ought  to 
be  underwritten.  Small  issues,  say  $500,000  or  less, 
can  usually  be  sold  to  a  comparatively  small  number  of 
investors  by  direct  solicitation  on  the  part  of  the  corpo- 
ration. Then  again,  well-established,  successful  corpo- 
rations frequently  sell  new  stock  or  bond  issues  to  their 
stockholders  at  bargain  prices.  Ordinarily  there  is  no 
risk  in  such  a  sale  and  consequently  no  necessity  for 
underwriting. 

An  interesting  concrete  case,  in  which  there  is  doubt 
as  to  whether  new  issues  of  bonds  should  be  underwritten 
or  not,  was  brought  to  public  attention  in  March,  1909. 
At  the  annual  meeting  of  the  stockholders  of  the  Penn- 
sylvania Railroad  Company  Mr.  Moorfield  Storey,  a 
Boston  lawyer,  submitted  the  following  resolution: 

Whereas,  The  Pennsylvania  Railroad  Company  is  to-day  the 
first  railroad  corporation  in  the  world,  and  its  securities  are  en- 
titled to  rank  with  the  best  that  can  be  offered,  and,  therefore, 
to  command  the  highest  price  in  the  markets,  both  of  this  and 
foreign  countries;  and. 

Whereas,  There  is  now  abundant  capital  in  the  hands  of 
capitalists  and  combinations  of  capitalists  the  world  over,  who 
are  seeking  opportunities  for  buying  such  securities,  and  it  is 
desirable  that  the  directors  of  this  company  should  take  ad- 
vantage of  the  opportunity  which  these  conditions  afford  to 
obtain  the  highest  price  possible  for  such  securities  as  the  com- 
pany now  proposes  to  sell;  and. 

Whereas,  The  sale  of  railroad  securities  to  the  highest  bidder 
after  open  competition  will  do  much  to  remove  the  public  be- 
lief that  such  securities  are  issued  for  excessive  amounts,  and 
thus  tend  to  prevent  legislation  adverse  to  these  corporations, 
which  is  now  threatened*  t/i^  J' <^f«'''^  I  t'^    ''t 

Resolved,  That  the  stockholders  of  the  Pennsylvania  Rail- 
road Company  desire  to  have  the  proposed  issue  of  securities 
so  offered  as  to  be  open  to  competitive  bidding  by  responsible 


THE  UNDERWRITING  SYNDICATE  261 

banking  houses,  and  that  the  issue  of  securities  should  be  ad- 
vertised in  advance,  it  being  required  that  such  bids  shall  be 
accompanied  by  certified  check  for  such  amount  as  may  be 
necessary  to  insure  good  faith. 

This  reasoning  sounds  plausible  at  the  first  hearing, 
but  is  far  from  convincing.  It  fails  to  take  unto  ac- 
count the  risks  involved  in  the  proposed  plan  and  the 
advantage  to  the  railroad  of  having  the  right  kind  of 
banking  connections  in  periods  of  financial  stress.  In 
the  course  of  an  able  discussion  of  this  proposal  the 
New  York  Evening  Post  says: 

Those  who  hold  different  views  appeal  to  the  Pennsylvania's 
own  experience  in  1903.  Early  in  that  year,  when  the  stock 
was  selling  around  157,  the  shareholders  were  offered  $75,000,- 
000  new  stock  at  120.  Before  the  time  for  closing  the  sub- 
scription list  expired,  the  price  of  the  old  stock  had  fallen 
almost  to  120,  and  the  management  was  confronted  with  the  diffi- 
culty that  beset  the  Steel  Corporation  the  same  year,  when 
bonds  which  had  been  offered  to  the  shareholders  at  par  were 
selling  in  the  open  market  at  65.  Needless  to  say,  the  Steel 
bonds  were  finally  sold  to  a  syndicate  and  not  to  the  shareholders. 
When  Pennsylvania  dropped  to  around  120,  in  the  spring  of 
1903,  a  banking  syndicate  was  hastily  formed  to  underwrite  the 
new  issue  for  which  a  commission  of  2%  per  cent  was  allowed. 
Before  the  whole  operation  was  concluded  the  old  stock  had 
touched  110%.  Under  favorable  conditions  a  road  in  such 
high  credit  as  the  Pennsylvania,  the  St.  Paul,  the  Great  North- 
ern, the  Union  Pacific,  the  IlHnois  Central,  or  the  North- 
western could  get  a  better  price  for  an  issue  of  bonds  by 
shopping  among  the  international  banking  houses  than  by  con- 
fining negotiations  to  one  banking  firm.  But  all  of  the  roads 
named  have  at  one  time  or  another  been  forced  to  borrow;  when 
the  prices  of  investment  securities  were  falling  or  when  money 
market  conditions  were  unfavorable. 

A  railroad  which  has  established  permanent  banking  connec- 


262  CORPORATION  FINANCE 

tions  has  a  guarantee  that  money  can  be  raised  in  troublesome 
times,  when  necessary,  as  well  as  when  investors  are  clamoring 
for  securities.  When  acting  in  such  capacity  bankers  are  sup- 
posed to  advise  a  railroad  what  kind  of  securities  will  find  the 
readiest  market,  exactly  when  the  securities  should  be  issued,  a 
very  important  point,  and  what  price  the  public  should  be 
asked  to  pay  for  the  issue.  It  is  also  the  business  of  railway 
bankers  to  protect  the  market  for  a  new  issue  until  the  securities 
reach  the  hands  of  investors. 

142.  Why  underwriting  syndicates  are  formed, — It 
would  naturally  be  expected  that  each  of  the  large 
financial  houses  engaged  in  the  underwriting  business 
would  handle  on  its  own  responsibility  whatever  busi- 
ness comes  its  way,  and  that  rivalry  would  prevent  their 
co-operating  to  any  considerable  extent.  The  fact  is, 
however,  that  these  houses  have  long  since  learned  that 
it  is  inadvisable  for  any  one  of  them,  no  matter  how 
powerful,  to  guarantee  the  success  of  a  large  security 
issue.  It  is  true  that  the  banker's  judgment  and  ex- 
perience should  enable  him  to  avoid  heavy  risks;  yet  a 
certain  amount  of  risk  is  inevitable.  A  banker  does  not 
know  what  may  happen  in  the  financial  world,  does  not 
know  when  the  bankruptcy  of  some  big  concern  or  un- 
expected political  events  may  create  a  sudden  panic. 
If  he  is  caught  at  such  a  time  with  his  funds  tied  up  in  a 
large  issue  of  new  and  unsalable  securities,  he  may  be 
forced  into  bankruptcy  and  is  almost  certain  to  suffer 
severe  loss.  It  is  not  considered  conservative  banking, 
therefore,  for  any  one  house  or  even  any  two  or  three 
houses  to  underwrite  a  large  issue.  Many  banking 
houses  follow  a  definite  policy  in  this  respect  and  refuse 
absolutely  to  underwrite  more  than  a  certain  sum,  say 
$100,000  or  $500,000  or  $1,000,000,  depending  on  the 
size  of  the  house,  even  when  the  risk  seems  particularly 
small. 


THE  UNDERWRITING  SYNDICATE  263 

JAnother  reason  for  co-operation  among  bankers  is 
that  each  house  desires  to  offer  a  variety  of  securities 
to  its  clientele.  It  it  specializes  too  much  or  offers  only  a 
few  securities,  it  cannot  expect  to  attract  and  hold  reg- 
ular customers. 

A  third  reason  for  co-operation  is  in  order  that  a 
broad  geographical  distribution  may  be  obtained  and  the 
sale  of  the  security  issue  be  made  correspondingly  easy. 
A  Pittsburg  steel  company,  we  will  say,  is  putting  out 
a  large  new  bond  issue  and  gets  a  New  York  banking 
house  to  underwrite  the  issue.  New  York  and  Pitts- 
burg investors  may  be  loaded  with  similar  bonds  already ; 
under  such  circumstances  the  New  York  banking  house 
will  certainly  invite  houses  in  Boston  and  Chicago  and 
other  centers,  which  are  not  yet  saturated  with  such 
bonds,  to  participate  in  the  underwriting. 

For  these  reasons  the  banks  and  brokerage  houses  that 
handle  this  business  on  a  large  scale  always  band  them- 
selves together  in  the  case  of  an  issue  of  considerable 
size  into  an  underwriting  syndicate.     By  means^of  thp 
syndicate  the  risk,  the  trouble  and  thej)rofitsjje  divided 
among  sgveraljiouses.     The  syndicate  so  formed  may 
jlong  toTahy  one  of  five  types. 
143.  Three Jyj^ies^f  gi/ndicg^e^.— Originally  the  nor- 
lal  arrangement  was  to  have  the  indicate  as  a  whole 
guarantee  the_^rice  of  the  issue,  and  let  the  corporation 
ittend  tojthe  selling.     Under  this  plan,  to  give  an  ex- 
iple,  a  corporation  putting  out  a  $5,000,000  bond  is- 
}ue  would  offer  the  bonds  to  the  public  at  a  fixed  price, 
Jay  95,  and  the  syndicate  would  agree  to  accept  any  of 
bhe  bonds  not  bought  by  the  public  at  a  lower  price,  say^ 
)0,     This  is  underwriting  in  the  original  sense  of  the^ 
^ord;  itjs  a  species  of  insurance.     Under  such  a  plan 
the  syndicate  would  have  two  sources  of  profit;  first,  a 


^64  CORPORATION  FINANCE 

commission  on  the  portion  sold  to  the  public,  or  a  fixed 
bonus;  and,  second,  the  difference  between  the  whole- 
sale price  to  them  and  the  retail  price  at  which  they 
would  ultimately  dispose  of  the  bonds.  The  ordinary 
commission  would  range  between  2  and  5  per  cent. 
This  type  is  seldom  used  nowadayjs,  principally  for  the 
reason  already  given  that  the  corporation  is  not_well 
equipped  to  attend  to  the  sale  of  securities 
''A  second  type,  also  rather  unusual,  is  a  syndicate 
formed  tgiake  ajr  "underwjjt^r's  option.Ji  Under  this 
plan  the  syndicate  takes  the  block  of  J)onds  or  stock  at 

ji^  fixed  pricei,  payable  only  as  resold^  As  fast  as  the 
syndicate  disposes  of  the  bonds  it  turns  over  the  proceeds 
to  the  corporation,  after  deducting  whatever  it  receives 
above  the  fixed  price.  The  corporation  pays  somewhat 
less  for  this  service  than  for  other  kinds  of  underwriting, 

Tbecause  the  syndicate  takes  no  riskj  on  the  other  hand, 

lis  the  corporation  cannot  be  certain  when  it  will  get  its 
money,  the  type  is  not  much  favored  by  conservative 
corporation  managers. 

The  third  type  of  syndicate  comes  into  existence  when 
a  large  banking  house  has  bought  for  itself  a  Jbig  secur- 
ity issue  and  wishes  to  distribute  the  risk.     In  sucITaT 
case  the  original  underwriter  frequently  calls  upon  other 
banking  houses  ^nd  upon  individuals  to  take  portions  of 

Ihe  issue  at  prices  low  enough  to  be  attractive.  The 
agreement  with  the  parties  who  are  called  in  may  be  ex- 
ecuted in  anticipation  of  a  contract  that  is  about  to  be 
made  between  the  original  underwriter  and  the  corpora- 
tion. Full  details  as  to  an  excellent  example  of  this 
type  of  underwriting  syndicate  will  be  found  in  the 
agreement  made  in  order  to  guarantee  the  conversion  of 
the  United  States  Steel  Corporation  preferred  stock, 
which  is  given  in  full  below. 


THE  UNDERWRITING  SYNDICATE  ^65 

7  IM,  A  fourth  type— pooling  the  sale  of  the  security^ 
— The  fourth  type  of  syndicate  acts  as  a  unit  in  making 
a  contract  for  the  purchase  of  an  issue  and  pools  the 
sale  of  the  stock  or  bonds.  The  chief  difference  between 
the  third  and  fourth  types  lies  simply  in  the  fact  that 
the^yiidicaje  m^embersj.eal  jirgc^^    with  the  corporation^ 

not  with  a  banking  house. They  thus  secure  for  them- 

gelves  all  thejprofits  of  the  underwriters..  Sijph  a  syndi- 
cate is  always  managed  by  some  one  house  6r  inffividiiar 
having  complete  authority.  Its  organization  and  man- 
agement are  further  discussed  below.  On  the  whole, 
this  is  probably  the  best  known  andjnost^commoaforni 
of  large  syndicates. 

To  illustrate  the  workings  of  this  type  we  will  sup- 
pose that  a  syndicate  has  been  formed,  under  the  leader- 
ship of  Speyer  &  Company,  to  underwrite  a  $25,000,000 
bond  issue  at  90 ;  to  the  public  the  price  of  the  issue,  we 
will  say,  is  95.  One  concern  may  agree  to  take  $1,000,- 
000,  or  one-twenty-fifth  of  whatever  amount  the  public 
fails  to  buy;  another  concern  may  take  $2,500,000,  or 
one-tenth  of  whatever  is  left  unsold,  and  so  on.  All  the 
bonds  are  left,  in  this  form  of  syndicate,  with  Speyer 
&  Company,  who  offer  the  bonds  to  the  public  and  sell 
all  that  they  can.  If  the  whole  issue  is  taken  by  the 
public,  each  party  to  the  syndicate  receives  his  profits, 
after  deducting  expenses,  without  further  trouble.  If 
the  public  does  not  take  the  whole  issue,  each  member 
must  take  his  agreed  proportion  at  the  syndicate  price, 
90.  In  good  times  the  risk  in  such  a  transaction  is 
slight ;  if  the  public  is  indisposed  to  buy  bonds,  however, 
or  if  any  serious  mistake  in  their  valuation  has  been 
made,  the  syndicate  members  may  lose  heavily. 

,^  145.  A  fifth  type — distributing  the  security. — The 
pooling  arrangement  above  described,  although  it  se- 


266  CORPORATION  FINANCE 

cures  (Centralized  and  efficient  management,  is  apt  to 
prove  unsatisfactory  in  that  it  does  not  bring  into  play 
the  whole  selling  machinery  of  the  various  syndicate 
members..  For  this  reason  it  has  become  more  and  more 
customary  of  late  years  to  distribute  the  security  issue_ 
.among  the  members  of  the  syndicate^,:^  This  is  the  fifth 
type  of  an  underwriting  syndicate.  Strictly  speaking, 
of  course,  the  distribution  of  securities  is  not  an  under- 
writing in  any  sense,  but  a  sale.  It^is  a  sale  at  a  special 
price,  however,  made  under  certain  restrictions  afid'He- 
signed  to  serve  exactly  the  same  purpose  as  true  under- 
writing ;  the  term  therefore  is  freely  applied  to  it  in  the 
Street.  Chief  among  the  restrictions  on  the  sale  is  an 
agreement,  either  tacit  or  written,  that  the  securities  shall 
not  be  resold  to  the  public  at  less  than  a  certain  fixed 
price.  Frequently  it  is  also  agreed  that  some  one  or  two 
of  the  syndicate  members  shall  be  given  the  first  oppor- 
tunity to  advertise  a  sale  of  the  securities,  and  that  the 
other  members  are  to  keep  out  of  the  open  market  for  a 
limited  period.  Such  an  agreement  would  not  bar  any 
of  the  syndicate  members  from  selling  the  securities  to 
their  regular  clients. 

Among  the  members  of  a  syndicate  of  this  type  there 
are  frequently  several  individuals  and  institutions  who 
are  buying  the  securities,  not  for  resale,  but  for  invest- 
ment; they  are  simply  getting  in  on  the  ground  floor, 
making  their  investment  at  the  special  syndicate  price. 
Readers  will  perhaps  recall  that  this  practice  was 
brought  to  public  attention  and  much  discussed  during 
the  great  insurance  investigation  of  1904.  Mr.  George 
W.  Perkins,  now  of  the  firm  of  J.  P.  Morgan  and  Com- 
pany, and  Mr.  James  H.  Hyde,  among  others,  alleged 
that  their  participation  as  individuals  in  syndicates, 
which  was  disclosed  during  the  investigation,  was  for  the 


THE  UNDERWRITING  SYNDICATE  267 

purpose  of  buying  bonds  at  especially  low  prices  for  the 
insurance  companies  which  they  represented.     One  ob;^ 
jection  to  allowing  investors  to  j)artjcjpate  in  syndicates^ 
^f  this  type  is  that  tiiey  may  decide  later  tq^sell  the 
securities  allotted  to  them  before  the  banking  members 
of  the  syndicate  are  through  selling,  and  may  thereby^ 
break  the  price.     With  the  view  to  avoiding  such  a  re- 
sult  syndicate   managers   are   exceedingly   careful   in 
choosing  members  who  buy  for  investment,  not  for  re- 
sale,,^ 

"^46.  The  large  underwriting  houses. — The  Wall 
Street  Journal^  in  a  recent  article  dealing  with  the  prac- 
tice of  the  big  corporations  in  disposing  of  bond  issues 
to  underwriting  syndicates  of  the  third,  fourth  and  fifth 
types,  says: 

One  method  is  to  sell  the  bonds  in  a  block  to  one  of  the 
great  underwriters.  Pennsylvania,  Baltimore  and  Ohio,  Union 
Pacific,  and  many  others,  sell  direct  to  Kuhn,  Loeb  &  Com- 
pany, get  the  money,  and  thereafter  take  only  an  indirect  in- 
terest in  the  bonds.  Rock  Island  sells  to  Speyer  &  Company, 
'Frisco  to  Blair  &  Company  and  others,  New  York  Central, 
Lake  Shore,  Southern  Railway,  Erie  and  others  to  J.  P.  Mor- 
gan &  Company.  The  price  at  which  these  railroads  sell  their 
bonds  to  the  underwriters  is  not  generally  known.  It  is  taken 
to  be  a  private  matter,  but  it  often  leaks  out. 

Another  method,  not  uncommon,  is  to  sell  the  bonds  to 
the  big  retail  bond  houses  who  distribute  them  to  a  wide  and 
wealthy  public  through  advertising  and  through  correspond- 
ence. Each  of  these  houses  has  its  clientele.  Some  are  strong 
in  New  York,  others  in  Canada,  others  in  the  South,  etc. 
They  are  more  or  less  specialists,  and  get  to  be  known  for  a 
particular  grade  of  bonds  or  stocks. 

These  two  methods,  of  course,  overlap  greatly.  Harvey 
Fisk  &  Sons,  for  instance,  known  for  years  as  a  big  retail  bond 
house  of  wide  clientele,  frequently  underwrite  whole  issues  of 


268  CORPORATION  FINANCE 

securities,  as  in  the  case  of  the  Electrical  Securities  collaterals, 
recently  brought  out.  Similarly,  Fisk  &  Robinson  took  the 
whole  issue  of  the  new  Buffalo  &  Susquehanna  Railway  4I/2S. 
J.  P.  Morgan  &  Company,  Kuhn,  Loeb  &  Company  and  Speyer 
&  Company  generally  participate  to  a  greater  or  less  extent 
in  any  extensive  new  bond  issue,  because  their  clientele  demands 
it,  even  though  these  firms  may  not  be  the  original  underwriters. 

Summing  up  what  has  been  said  with  regard  to  the 
various  types  of  underwriting  syndicates,  it  is  evident 
that  the  tendency  is  growing  for  the  corporation  to  sell 
its  new  security  issues  at  fixed  prices  to  the  large  bank- 
ing houses  and  then  wash  its  hands  of  the  business  of 
selling  the  securities.  Experience  has  demonstrated 
that  this  is  the  best  method  for  the  corporation.  Bank- 
ing houses  also  preferthis,method  to  the  original  under- 
writing, which  consisted  simply  Jn  guaranteeing  the 

"price,  for  two  reasons :  first,  because  they  can  thus  con- 
trol  the  price  and  time  of  sale  and  bring  to  bear  their 
skill  in  selling;  second,  because  the  underwriters,  having 

~Tull  control  of  the  securities,  can  post  them  as  collateral 
and  secure  bank  loans,  thereby  reducing  their  direct 
"i^h  obligations. 

In  making  this  last  statement  the  writer  has  in  mind 
the  distinction  between  "banking  houses"  and  "banks"] 
which  may  not  be  familiar  to  all  readers.     "Banking 
houses,"  so-called,  seldom  carry  dejgosits  to  any  greal 
extent  from  other  people,  and  do  not  make  a  business  oJ 
loaning  money.     Their  chief  interests  lie  in  buying  am 

felling  securities*-^  "Banks,"  on  the  other  hand,  drawj 
their  profits  mainly  from  receiving  deposits  and  makin j 
loans. 


CHAPTER  XIX 

THE    MANAGEMENT  OF  THE  UNDERWRITING 
SYNDICATE 

147.  Informal  agreements. — As  there  are  only  a  few 
large  banking  houses  and  institutions,  even  in  the  whole 
country,  which  ordinarily  take  part  in  large  underwrit- 
ing syndicates  and  as  these  houses  are  thoroughly  fa- 
miliar with  each  others'  policies  and  resources,  the  agree- 
ments among  them  are  frequently  quite  informal.  In 
one  large  transaction  recently,  as  was  later  brought  out 
on  the  witness  stand,  J.  P.  Morgan  and  Company 
formed  an  underwriting  syndicate  simply  by  allotting  a 
certain  proportion  of  the  security  issue  to  each  of  several 
large  firms  and  institutions.  The  members  of  the  syndi- 
cate were  not  consulted  at  all  or  even  advised  in  writing, 
but  were  merely  called  on  the  telephone  and  notified  of 
their  participation.  The  informality  was  possible  in 
this  case  because  the  syndicate  was  expected  to  make 
good  profits  and  J.  P.  Morgan  and  Company  well  knew 
that  everyone  concerned  would  gladly  take  as  large  an 
allotment  as  the  syndicate  managers  would  grant. 

148.  A  formal  syndicate  agreement, — Ordinarily, 
however,  a  formal  syndicate  agreement  is  drawn  up  and 
signed.  As  these  agreements  are  not  generally  made 
public,  their  exact  terms  seldom  become  known.  The 
most  elaborate  and  perhaps  the  most  important  agree- 
ment of  this  nature  that  has  been  given  out,  was  produced 
on  the  witness  stand  in  the  famous  suit  to  prevent  the 
conversion  of  United  States  Steel  preferred  stock  into 
bonds,  referred  to  in  Chapter  XV.     The  agreement  is 

269 


270  CORPORATION  FINANCE 

of  such  interest  and  importance  that  it  is  given  in  full 
below: 

U.   S.   STEEL   CORPORATION   PREFERRED   STOCK   RE- 
TIREMENT SYNDICATE  AGREEMENT. 

An  agreement  made  the  12th  day  of  March,  1902,  by 
and  between  J.  P.  Morgan  &  Co.,  co-partners,  as  Bankers,  of 
the  City  of  New  York,  parties  of  the  first  part,  and  the  sub- 
scribers hereto  (hereinafter  called  severally,  parties  of  the  sec- 
ond part). 

Whereas,  The  United  States  Steel  Corporation  (herein- 
after called  the  "Steel  Company")  proposes  to  make  with  J. 
P.  Morgan  &  Co.,  a  certain  contract  or  contracts  whereunder 
in  behalf  and  on  account  of  the  Steel  Company  they  are  to 
offer  to  all  of  the  preferred  stockholders  of  the  Steel  Company, 
severally  and  ratably,  the  preferential  opportunity  of  subscrib- 
ing for  and  of  taking  at  par  the  "Ten-Sixty  Year"  Five  Per 
Cent  Sinking  Fund  Gold  Bonds  of  the  Steel  Company  in  even 
amounts  approximately  equal  to  40  per  cent  of  their  several 
holdings  of  preferred  stock,  such  subscriptions  to  be  payable  in 
such  preferred  stock  at  par,  provided  that  every  such  subscrip- 
tion stockholder  at  the  time  of  such  original  subscription  pay- 
able in  preferred  stock  shall  have  the  right  of  his  option  then  to 
make  an  additional  subscription  payable  in  cash  for  such  bonds 
to  an  amount  equal  to  25  per  cent  of  his  stock  subscription; 
such  bonds  to  be  authorized  now  for  the  principal  sum  of 
$250,000,000  and 

Whereas,  in  and  by  such  contracts  J.  P.  Morgan  &  Co. 
are  to  guarantee  to  the  Steel  Company,  that  subscriptions  for 
such  bonds  will  be  made  for  the  aggregate  sum  of  at  least 
$100,000,000,  payable  in  preferred  stock  to  the  extent  of  four-j 
fifths  of  said  sum,  and  in  cash  for  the  remaining  one-fifthj 
thereof;  such  contracts  to  provide  for  the  payment  or  allow- 
ance to  J.  P.  Morgan  &  Co.,  of  a  commission  of  4  per  cent 
upon  the  aggregate  par  amount  of  all  such  bonds,  which  shall 
be  sold  and  delivered  under  their  said  offer,  or  to  them,  they 


SYNDICATE  MANAGEMENT  271 

having  the  prior  right  to  take  all  of  such  bonds  which  shall  be 
offered  for  subscription^  and  which  shall  not  be  taken  by  the 
preferred  stockholders  under  such  offer;  and 

Whereas,  upon  the  terms  of  this  agreement,  and  for  the 
purposes  above  mentioned  all  of  the  parties  hereto  now  desire 
to  form  a  syndicate  to  provide  and  to  furnish  to  J.  P.  Morgan 
&  Co.  for  delivery  to  the  Steel  Company  the  preferred  stock, 
and  the  cash  required  under  their  said  guaranty,  and  to  receive 
frem  J.  P.  Morgan  &  Co.,  four-fifths  of  the  net  commissions  by 
them  received  under  the  said  contract  or  contracts  with  the 
Steel  Company,  which  contracts  J.  P.  Morgan  &  Co.  are  au- 
thorized from  time  to  time  to  make,  modify  and  perform,  as  in 
the  exercise  of  their  unlimited  discretion  from  time  to  time  the}^ 
may  deem  proper,  do  agree,  as  follows,  viz. : 

First.  On  signing  this  agreement  each  subscriber  has 
delivered  to  J.  P.  Morgan  &  Co.  certificates  for  preferred  stock 
of  the  Steel  Company  in  the  amount  indicated  in  his  stock  sub- 
scription hereto,  which  preferred  stock,  to  such  extent  as  may 
be  required  to  meet  the  requirements  of  their  said  guaranty, 
is  to  be  delivered  to  the  Steel  Company  at  par  in  exchange  for 
the  Ten-Sixty  Year  Five  Per  Cent  Gold  Bonds  of  the  Steel 
Company  for  an  equal  amount  at  par,  to  be  received  therefor 
by  any  subscriber,  and  any  such  preferred  stock  not  so  delivered 
to  the  Steel  Company  is  to  be  returned  to  the  subscribers  rata- 
bly according  to  their  several  subscriptions. 

Second.  Each  subscriber  further  agrees  to  pay  J.  P. 
Morgan  &  Co.  in  cash  the  sum  specified  in  his  cash  subscription 
hereto,  for  which  cash  J.  P.  Morgan  &  Co.  shall  receive  from 
the  Steel  Company  bonds  as  aforesaid  at  par  equal  to  the 
amount  of  such  cash  payment  by  such  subscribers. 

Third.  The  several  deliveries  and  undertakings  of  the 
several  subscribers  under  this  agreement  shall  be  made  and  per- 
formed by  the  subscribers  respectively  when  and  as  requested 
by  J.  P.  Morgan  &  Co.  or  by  the  subscribers,  of  any  of  said 
Five  Per  Cent  Sinking  Fund  Gold  Bonds  of  the  Steel  Company. 

Fourth.     The  several  subscribers  shall  be  called  upon  to 


272  CORPORATION  FINANCE 

make  payments  of  cash  in  respect  of  their  several  subscriptions 
only  ratably  according  to  the  several  amounts  thereof ;  but  each 
subscriber  shall  be  so  responsible  to  the  full  extent  of  the  sev- 
eral undertakings  regardless  of  performance  or  non-perform- 
ance by  any  other  subscriber.  In  the  same  proportion  except 
as  otherwise  provided  the  several  subscribers  shall  be  responsible 
for  loss  resulting  to  the  Syndicate  under  this  agreement.  Noth- 
ing herein  contained  shall  constitute  the  parties  hereto  partners, 
or  shall  render  any  of  the  subscribers  liable  to  contribute  more 
than  his  several  proportionate  amount  as  herein  provided. 

Fifth.  In  the  case  of  the  failure  of  any  subscriber  to 
perform  any  of  his  undertakings  hereunder  as  and  when  called 
for  by  them,  J.  P.  Morgan  &  Co.  in  behalf  of  themselves  and 
the  syndicate  shall  have,  and  at  their  sole  and  exclusive  option 
they  may  exercise,  the  right  to  exclude  such  subscriber  from 
all  interest  in  the  Syndicate,  and  in  their  discretion,  without 
any  proceedings,  either  at  law  or  in  equity,  they  may  dispose 
of  such  subscriber's  participation  hereunder  of  any  interest 
or  right  of  such  subscriber  hereunder  or  under  any  of  said 
proposed  contracts,  but  nevertheless,  each  subscriber  in  default 
shall  be  responsible  to  J.  P.  Morgan  &  Co.  for  the  benefit  of 
themselves  and  the  other  subscribers  hereto  for  all  damages 
caused  by  any  failure  on  his  part.  At  any  public  sale  under 
this  article  of  any  interest  or  right  of  any  subscriber  J.  P. 
Morgan  &  Co.  or  any  party  thereto  may  become  purchaser 
for  their  or  for  his  own  benefit,  without  accountability;  bu*- 
notwithstanding  any  sale,  whether  public  or  private,  the  de- 
faulting subscriber  shall  be  responsible  to  J.  P.  Morgan  &  Co. 
and  to  the  Syndicate  for  all  damages  caused  by  such  failure  on 
his  part. 

Sixth.  J.  P.  Morgan  &  Co.  shall  have  full  power  in  their 
discretion  from  time  to  time,  to  agree  with  the  Steel  Company 
upon  the  terms  and  provisions  of  any  contracts  such  as  are 
above  referred  to;  and  also,  from  time  to  time,  to  enter  into 
any  agreements  with  the  Steel  Company  modifying  the  said 
contracts  as  they  may  deem  expedient.  They  may  deliver  to 
the  Steel  Company  a  copy  of  this  agreement,  having  annexed 


SYNDICATE  MANAGEMENT  273 

thereto  a  list  of  the  subscribers;  and  thereupon  to  the  extent 
of  their  several  subscriptions,  the  subscribers,  severally  and 
respectively,  but  not  jointly,  and  no  one  for  any  other,  shall 
become  responsible  for  the  performance  of  such  contracts  with 
the  Steel  Company  in  discharge  of  the  obligations  thereunder 
of  J.  P.  Morgan  &  Co.  Any  and  all  contracts  with  the  Steel 
Company  made  by  J.  P.  Morgan  &  Co.  shall  be  open  to  in- 
spection by  any  subscriber  at  the  office  of  J.  P.  Morgan  &  Co. 

Seventh.  J.  P.  Morgan  &  Co.  shall  be  the  sole  and 
final  judges  as  to  whether  at  any  time  it  is  to  the  interest  of 
the  Syndicate  to  proceed  further  under  this  agreement  or  under 
said  proposed  contracts;  and  wherever  they  may  deem  ex- 
pedient, they  may  abandon  the  objects  contemplated,  in  this 
agreement  and  said  proposed  contracts  and  all  further  proceed- 
ings thereunder.  In  such  event  all  the  cash  or  stock  and  bonds 
by  them  received  and  then  held  for  account  of  the  Syndicate, 
and  the  proceeds  of  such  stock  and  bonds  shall  remain  charged 
with  the  payment  of  all  expenses  and  liability  by  them  incurred 
hereunder  and  shall  be  applied: — 

First  to  the  payment  of  any  and  all  expenses  and  obligations 
incurred  by  J.  P.  Morgan  &  Co.  under  any  provisions  of  this 
agreement. 

Secondly y  in  repayment  to  the  subscribers  (so  far  as  the 
same  may  be  sufficient  for  that  purpose)  of  all  amounts  of 
preferred  stock  or  of  cash  by  them  respectively  dehvered  here- 
under to  J.  P.  Morgan  &  Co.,  such  repayment  to  be  made  to  the 
subscribers  ratably. 

Eighth.  J.  P.  Morgan  &  Co.  shall  be  sole  managers  of 
the  Syndicate,  and  in  behalf  of  the  Syndicate  they  may  make 
any  and  all  arrangements,  and  may  perform  any  and  all  acts, 
even  though  not  herein  provided  for,  in  their  opinion  necessary 
or  expedient  to  carry  out  the  purposes  of  this  agreement,  or 
to  promote  or  to  protect  what  they  deem  to  be  the  best  interests 
of  the  Syndicate. 

The  enumeration  of  specific  powers  in  this  or  in  any  other 

article  of  this  agreement  shall  not  be  construed  as  in  any  way 
1—18  *^ 


274.  CORPORATION  FINANCE 

abridging  the  general  powers  of  this  article  Intended  to  be  con- 
ferred upon  or  reserved  to  J.  P.  Morgan  &  Co. 

Ninth.  From  time  to  time  before  October  1,  1903,  J.  P. 
Morgan  &  Co.  in  behalf  of  the  Syndicate,  may  make  sales  of  all 
or  any  part  of  the  bonds  received  by  them  for  account  of  the 
Syndicate.  Any  such  sales  may  be  made  by  J.  P.  Morgan  & 
Co.  either  publicly  or  privately,  by  themselves,  or  in  such  man- 
ner as  they  may  deem  proper,  and  shall  be  upon  such  terms  and 
for  such  price  or  prices  as  they  may  deem  expedient.  Each 
subscriber  hereby  assents  to,  and  agrees  to  be  bound  by  any 
such  action. 

No  subscriber  shall  be  entitled  to  receive  any  of  said  bonds 
before  October  1,  1903.  In  the  meantime,  in  their  discretion, 
J.  P.  Morgan  &  Co.  either  themselves  may  retain  all  or  any 
part  of  such  bonds,  or  they  may  deliver  to  any  subscriber  his 
proportionate  part  thereof,  upon  his  agreement  to  hold  the 
same  subject  to  sale  by  J.  P.  Morgan  &  Co.  and  to  return  the 
same  upon  call  of  J.  P.  Morgan  &  Co.  at  any  time  before  Octo- 
ber 1,  1903. 

Should  any  subscriber  desire  to  withdraw  from  sale  the  por- 
tion of  bonds  to  which  he  may  be  entitled  hereunder,  J.  P. 
Morgan  &  Co.,  in  their  discretion  may  deliver  to  any  sub- 
scriber his  portion  of  such  bonds  upon  his  agreement  to  hold  the 
same  for  himself  without  sale  until  October  1,  1903,  or  until  the 
complete  sale  by  J.  P.  Morgan  &  Co.  at  an  earlier  date  of  all 
bonds  held  by  or  for  the  Syndicate. 

Tenth.  Until  October  1,  1903,  or  until  the  final  distribu- 
tion hereunder,  J.  P.  Morgan  &  Co.  in  such  manner,  at  such 
prices,  on  such  terms,  and  in  such  amounts  as  they  may  deem 
expedient,  shall  have  power  for  account  of  the  Syndicate,  to 
make  purchases  of  the  5  per  cent  gold  bonds  and  of  the  pre- 
ferred stock  of  the  Steel  Company,  and  they  may  resell  any 
such  bonds  and  stocks  which  they  may  have  purchased  and  in 
their  discretion  they  may  make  any  further  undertakings  of 
any  kind  with  any  persons  concerning  any  such  bonds  and 
stocks.     They   may   apply   towards    any   such   purchases   any 


SYNDICATE  MANAGEMENT  275 

sums  realized  from  any  sales  of  bonds  and  stocks  of  the  Steel 
Company  under  any  provisions  of  this  agreement;  and  they 
may  make  advances,  or  may  procure  loans,  and  may  secure  the 
same  to  such  amounts  and  in  such  manner  as  from  time  to  time 
they  may  deem  expedient  for  any  of  the  purposes  of  this  agree- 
ment. 

Eleventh.  J.  P.  Morgan  &  Co.  shall  issue  to  the  sub- 
scribers suitable  receipts  in  respect  of  payments  made  here- 
under, and  they  may  issue  to  the  respective  subscribers  certifi- 
cates of  interest  of  such  tenor  and  form  as  they  may  deem 
suitable.  Such  certificates  of  interest  and  rights  and  obliga- 
tions hereunder  of  the  respective  subscribers  may  be  made  trans- 
ferable in  such  manner  and  on  such  terms  and  conditions  as 
J.  P.  Morgan  &  Co.  may  prescribe. 

Twelfth.  J.  P.  Morgan  &  Co.  shall  have  authority 
from  time  to  time  and  at  any  time  to  incur  such  expenses  as 
they  may  deem  proper  in  carrying  out,  or  endeavoring  to  carry 
out,  this  agreement  or  said  proposed  contracts,  or  in  doing  any 
act  or  thing  which  they  may  deem  to  be  in  the  interest  of  the 
Syndicate,  and  all  such  expenses  shall  constitute  and  be  a  prior 
charge  in  their  favor  upon  any  and  all  moneys,  stocks  and 
bonds  by  them  received  or  held  hereunder.  Any  and  all  moneys 
by  them  received  hereunder  shall  hold  by  them  as  bankers 
in  general  account.  Thej'^  also  shall  have  power  and  authority, 
in  their  sole  and  absolute  direction,  finally  to  fix  and  pay  all 
compensations  or  depositaries,  brokers,  agents  and  counsel,  or 
others,  and  in  the  expense  account  may  be  included  brokers' 
commissions  as  usually  paid. 

Thirteenth.  After  the  complete  performance  of  the  en- 
tire obligation  of  the  Syndicate  hereunder,  but  not  before 
the  first  day  of  October,  l903,  unless  otherwise  determined  by 
J.  P.  Morgan  &  Co.,  in  the  exercise  of  their  unrestricted  dis- 
cretion, payment  may  be  made  to  the  Syndicate  by  J.  P.  Morgan 
&  Co.  for  the  purpose  of  this  agreement,  out  of  any  moneys  for 
such  purposes  received  or  retained  by  J.  P.  Morgan  &  Co. 

FouETEENTH.  J.  P.  Morgan  &  Co.  shall  not  be  liable 
under  any  of  the  provisions  of  this  agreement  nor   for  any. 


276  CORPORATION  FINANCE 

matter  therewith  connected  except  for  good  faith  in  perform- 
ing or  in  refraining  from  performing  or  carrying  out,  the  obli- 
gations by  them  herein  expressly  assumed;  the  implication 
of  any  obligation  not  herein  expressly  assumed  by  them  being 
hereby  expressly  denied  and  waived. 

It  is  understood  that,  in  the  same  manner  as  other  subscribers, 
J.  P.  Morgan  &  Co.  may  become  subscribers  hereto,  that  as 
such  subscribers  they  shall  be  liable  for  all  subscriptions  by 
them  made,  and  that  in  all  respects  they  shall  be  entitled  to  the 
same  rights  and  benefits  as  any  other  subscriber.  Any  sub- 
scriber hereto  may,  on  his  own  account,  make  any  agreement 
with  any  other  subscriber  or  with  the  Steel  Company. 

Fifteenth.  This  agreement  shall  bind,  and  is  for  the 
benefit  of  the  parties  hereto  and  their  administrators  and  execu- 
tors, severally  and  respectively,  but  no  assignment  hereunder 
shall  be  valid  unless  assented  to  in  writing  by  J.  P.  Morgan  & 
Co. 

All  rights  and  powers  J.  P.  Morgan  &  Co.  hereunder  shall 
vest  in  said  co-partnership  firm,  as  from  time  to  time  consti- 
tuted, without  further  act  or  assignment. 

Sixteenth.  Nothing  herein  contained  shall  be  construed 
as  creating  any  trust  or  obligation  whatsoever  in  favor  of 
any  person  or  corporation  other  than  the  subscribers,  nor 
any  obligation  in  favor  of  the  subscribers  excepting  only  as 
herein  is  expressly  provided. 

Seventeenth.  Each  subscriber  shall  set  opposite  his 
subscription  hereunder  an  address,  to  which  notices,  calls  or 
other  communications  may  be  sent,  and  any  notice,  call  or  other 
communication  addressed  to  any  subscriber  at  the  address  so 
given,  and  either  at  such  address  or  mailed,  shall  be  deemed  ac- 
tually given  to  such  subscriber,  and  shall  be  sufficient  for  all  the 
purposes  hereof.  If  any  subscriber  shall  fail  so  to  furnish  an 
address  to  J.  P.  Morgan  &  Co.,  he  shall  not  be  entitled  to  any  no- 
tice of  calls  or  offers,  or  any  other  notice  hereunder,  and  he  shall 
be  deemed  to  assent  to  any  action  of  J.  P.  Morgan  &  Co. 

Eighteenth.  In  consideration  of  the  irrevocable  rights 
in    them   vested   hereunder,   and    the    promises    of   the   several 


SYNDICATE  MANAGEMENT  277 

subscribers,  J.  P.  Morgan  &  Co.  have  become  parties  to,  and 
in  good  faith  will  endeavor  to  consummate  the  purposes  of 
this  agreement;  and,  after  receipt  thereof  from  the  Steel  Com- 
pany, they  will,  as  herein  provided,  deliver  to  the  Syndicate  the 
said  Five  Per  Cent  Gold  Bonds,  or  the  proceeds  thereof,  and 
the  said  cash  compensation. 

In  witness  whereof,  the  parties  of  the  first  part  have 
hereunto  affixed  their  signatures,  and  the  parties  of  the 
second  part  at  various  dates  have  affixed  their  subscriptions 
hereto,  it  being  understood  that  for  convenience  this  agreement 
may  be  subscribed  in  several  parts  and  copies  with  the  same  force 
and  effect  as  if  all  the  subscriptions  were  on  one  part  or  copy 
thereof. 

SUBSCRIPTION  FOR  FIVE  PER  CENT  GOLD  BONDS. 
Name  Address  Preferred  Stock  Cash 

149.  Characteristics  of  syndicate  agreements. — The 
most  prominent  feature  of  this  agreement,  as  the  reader 
has  no  doubt  observed,  is  the^bsolute  and  unrestricted 
authority  retained  by  the  managers  of  the  syndicate. 
"Such  phrases  as  "J.  P.  Morgan  &  Company  shalTTiave 
full  power  in  their  discretion,"  "J.  P.  Morgan  &  Com- 
pany shall  be  the  sole  and  final  judges,"  "J.  P.  Morgan 
&  Company  shall  have  authority  from  time  to  time  and 
at  any  time,"  "J.  P.  Morgan  &  Company,  in  the  exer- 
cise of  their  unrestricted  discretion,"  and  so  on,  abound. 
In  this  respect  the  agreement  is  typical  of  all  underwrit- 
ing syndicates.  Indeed,  it  is  easy  to  see  that  without 
such  unrestricted  authority  the  syndicate  managers 
could  not  carry  on  their  operations  with  the  necessary 
promptness  and  secrecy.  The  real  check  to  any  abuse 
of  this  power  is  to  be  found  in  the  necessity  resting  on 
each  banking  firm  to  preserve  its  reputation  for  integrity 
absolutely  unstained. 

For  the  same  reason  this  agreement,  like  most  other 


278  CORPORATION  FINANCE 

such  agreements,  is  marked  by  open  dealing,  so  far  as 
the  essential  things  are  concerned.  At  the  very  begin- 
ning of  the  agreement  J.  P.  Morgan  and  Company 
state  the  commission  which  they  are  to  receive.  There 
is  nothing  on  their  part  concealed  from  the  other 
syndicate  members;  they  state  clearly  what  their  profits 
and  what  the  profits  of  each  member  are  to  be.  The 
same  rule  holds  true  even  in  cases  where  the  original 
underwriter  is  to  make  an  extra  profit  over  and  above 
what  goes  to  the  other  syndicate  members.  Secret  prof- 
its are  not  permissible  under  the  code  of  ethics  that 
governs  underwriting  transactions. 

Sometimes  it  happens  that  one  of  the  underwriting 
firms  fiunds  its  allotments  too  large  for  some  reasQlL^in 
which  case  it  will  probably  form  a  sub-syndicate.  The 
members  of  the  sub-syndicate  are  usually  individuals  or 
smaller  banking  fii^ms.  They  are  not  brought  into  con- 
tact at  all  with  the  original  syndicate  and  have  no  part  in 
its  workings,  but  are  responsible  solely  to  the  other 
members  of  the  sub-syndicate. 

150.  Functions  of  underwriting  syndicates, — Under- 
writing syndicates  may  handle  the  securities  of ^ 

(a)  Established  corporations. 

(b)  Reorganized  corporations. 

(c)  New  corporations. 

The  first  case  is  the  one  that  has  been  kept  in  view  so  far 
in  this  discussion  and  need  not  be  further  considered. 
The  second  case  presents  some  points  of  diiFerence  which 
will  be  referred  to  in  the  chapters  dealing  with  reor- 
ganization. In  both  cases  the  syndicate  is  handling  in- 
vestment securities  and  its_SQle^it)HenLJs_to^ii]^^ 
those  securities  to  the  best  advantage.  The  third  case 
Is  closely  allied  with  promotion;  the  syndicate  methods 
in  this  case  require  some  further  consideration. 


SYNDICATE  MANAGEMENT  279 

151.  Underwriting  speculative  securities, — The  se- 
curities of  a  new  corporation,  no  matter  how  brilliant 
its  prospects  may  be,  are  almost  always  speculative;  the 
only  exception  is  when  a  new  corporation  is  formed  to 
take  over  a  business  already  established,  and  this  excep- 
tion we  need  not  consider  here.  The  first  distinction, 
then,  between  a  syndicate  formed  to  underwrite  the  se- 

/  curities  of  a  new  corporation  and  other  syndicates  is  that 
it  is  handling^ocks  and  bonds  of  doubtful  value  which 

it  cannot  recommend,  unre&ervedty, 

A  second  distinction  is  that  the  syndicate  must  be 
prepared  to  put  up  more  cash  or  furnish  more  credit  in 
proportion  to  the  size  of  the  security  issues  than  would 
ordinarily  be  necessary.  This  follows  from  the  fact 
that  conservative  banks  are  not  willing  to  lend  much^ 

^  money  on  speculative  stocksjiidbonds. 

A  third  distinction  is  that  the  syndicate  must  be  pre- 
pared to  carry Jhepropositimi-throu^hJi)Jhe  end;  in  no 
ot^ier  3vay_£^cept  at  an  enormous  sacrifice  Qan  the  money^ 
needs  of  the  new  corporation  bejnet. 

^  A  fourth  distinction  lies  in  the  fact  that  for  their  own 
protection  the  syndicate  members  must  build  up  and 
maintain  the  credit  ofjbhe  new  corporation. 

^  Evidently  there  are  several  difficult  and  dangerous 
p^ddems  here  to_be  solved.  It  is  essential  to  their  so- 
lution th_at  the  syndicate  should  absolutely  control  the 
new  corporatioii.  _  Without^  control  measures  may  be 
taEen  that  will  impair  the  credit  of  the  corporation  and 
bring  heavy  losses  upon  the  syndicate.  Even  with  full 
control  such  enterprises  are  usually  deemed  too  risky  to 
be  participated  in  by  banking  houses  of  the  best  class. 
At  least  if  such  houses  do  enter  the  syndicate  they  accept 
only  small  allotments,  knowing  full  well  the  danger  of 
becoming  more  deeply  involved  as  the  enterprise  pro- 


280  CORPORATION  FINANCE 

ceeds.  No  one  can  tell  in  advance  what  the  cash  re- 
quirements of  a  new  corporation  may  be. 

Each  enterprise  of  this  nature  has  its  own  variations 
of  the  difficulties  and  dangers  that  have  been  cited  and 
requires  a  solution  that  will  exactly  fit  its  own  peculi- 
arities. Perhaps  the  best  way  of  explaining  the  usual 
solution  will  be  to  present  the  facts  of  a  particular  in- 
stance with  which  the  writer  happens  to  be  familiar. 

152.  An  example  of  speculative  underwriting. — In 
the  spring  of  1902  the  promoter  of  a  smelting  and  re- 
fining company  in  Mexico  succeeded  in  convincing  a 
number  of  Philadelphia  financiers  that  his  proposition 
was  worth  looking  into.  They  made  a  thorough  investi- 
gation, satisfied  themselves  that  the  proposed  plant 
would  certainly  prove  profitable,  and  undertook  to 
finance  its  construction.  Engineers'  estimates  called  for 
an  expenditure  of  something  over  $2,000,000  and  a 
period  of  three  years  before  the  plant  would  begin  to 
earn  expenses.  As  a  matter  of  fact,  the  expenditure 
was  approximately  $3,000,000  and  the  construction  work 
was  not  completed  until  early  in  1907. 

A  syndicate  of  Philadelphia  and  Baltimore  capital- 
ists and  banking  houses  was  formed  to  underwrite  the 
enterprise.  Next  an  entirely  different  syndicate  of 
banking  houses  was  organized,  which  agreed  to  take  the 
notes  when  issued  up  to  a  certain  amount  of  syndicate 
No.  I,  the  notes  to  be  secured  by  the  stock  of  a  corpora- 
tion organized  to  construct  the  plant.  The  corporation 
was  capitalized  at  $2,000,000,  half  preferred  and  half 
common  stock.  All  its  stock  was  sold  to  syndicate  No. 
I,  for  $1,000,000.  Syndicate  No.  I  then  posted  the 
stock  and  gave  notes  to  syndicate  No.  II,  who  loaned 
the  $1,000,000.  Thus  syndicate  No.  I  was  not  called 
upon  for  cash,  except  for  expenses,  and  the  construction 


SYNDICATE  MANAGEMENT  £81 

company  was  supplied  with  $1,000,000  with  which  to 
begin  operations. 

Next,  after  expending  the  $1,000,000,  the  construction 
company  issued  $500,000  of  its  own  notes,  which  being 
its  only  obligations  were  accepted  by  Philadelphia  banks. 
The  discount  on  this  and  the  other  sales,  for  the  sake  of 
simplicity,  we  will  eliminate.  Up  to  this  point  one-half 
the  necessary  funds  had  been  secured  and  at  the  end  of 
two  years  the  work  of  construction  had  been  more  than 
half  completed.  Now  a  new  corporation  was  formed 
which  was  to  operate  the  plant.     The  reader  will  observe 

that  the  first  corporation  existed  simply  to  carry  on  con: - 

struction.  The  operating  corporation  at  once  took  over 
the  stock  of  the  construction  company,  title  to  which  up 
to  this  time  had  remained  with  syndicate  No.  I.  Then 
the  operating  corporation  put  out  a  first-mortgage  bond 
issue,  based  on  all  its  property  then  owned  and  thereafter 
to  be  constructed,  and  sold  during  the  next  two  years 
$1,500,000  of  bonds.  In  this  way  the  whole  $3,000,000 
necessary  to  builtl4;he  plant  was  raised  by  borrowing 
and  the  members  of  syndicate  No.  I  furnished  nothing 
to  the  enterprise  but  their  credit.  The  diagram  on  page 
282  will  perhaps  assist  the  reader  in  arriving  at  a  clear 
understanding  of  the  whole  series  of  transactions. 

The  plant  at  the  date  of  writing  has  been  running  a 
little  over  two  years.  Earnings  have  been  more  than 
sufficient  to  meet  all  interest  charges  and  other  expenses, 
and  it  is  expected  that  large  profits  will  be  earned  in  the 
future.  Although  the  enterprise  is  not  yet  beyond  the 
speculative  stage,  its  chief  difficulties  have  been  over- 
come and  its  prospects  appear  bright.  The  first  use  to 
which  surplus  earnings  will  be  devoted,  according  to  the 
present  plans,  will  be  the  paying  off  of  the  $1,000,000 
of  notes  issued  by  syndicate  No.  I,  and  of  the  $500,000 


283 


CORPORATION  FINANCE 


SYNDICATE  MANAGEMENT  S83 

notes  of  the  construction  company.  As  soon  as  these 
obligations  are  met  the  construction  company  may  be 
dissolved  and  the  operating  company  will  begin  to  pay, 
it  is  expected,  big  dividends. 

It  may  seem  strange  that  a  new  plant  could  thus  be 
constructed  wholly  with  borrowed  funds;  yet  there  is 
nothing  especially  unusual  about  the  operation.  The 
secret  oXjhe_success^of  the  syndicate  in  this  instance  lay 
in  the  fact  that  they  were  themselves  strong  financially  _ 
and  could  borrow^  the  first  $1,000,000  readily.  ,  This 
left  a  margin  of  safety  to  those  who  loaned  funds  directly 
to  the  two  corporations.  Furthermore,  the  syndicate 
members  were  shrewd  and  prudent  enough  not  to  use 
up  all  the  available  credit  of  their  corporations  at  the 
beginning.  On  the  contrary,  the  essential  feature  oL- 
their  plan  of  operation  was  to  leave  the  best  lien  till  the 
last.  Thus  they  were  able  to  borrow  $1,500,000  on  first 
mortgage  bonds  at  a  time  when  most  corporations  under 
ordinary  management  would  have  been  compelled  to  call 
on  their  stockholders  for  funds. 

STuch  more  compEcated  instances  might  have  been 
\  (cited.  The  principles  followed  in  all  those  that  havef 
proved  successful,  however,  have  been  the  same,  namely : 
utilize  the  credit  of  the  backers  of  the  corporation  at  the 
beginning  and  save  the  best  security  that  the  corporation 
can  offer  till  the  end.  Working  in  this  way,  the  under- 
writing syndicates  of  new  corporations  frequently  bor- 
row large  sums  on  advantageous  terms. 


I 


CHAPTER  XX 

INVESTMENT  OF  CAPITAL  FUNDS 

153.  The  importance  of  wise  investment. — The  next 
question  that  confronts  the  promoter  or  manager  of  a 
new  corporation  after  he  has  succeeded  by  one  means  or 
another  in  raising  the  necessary  funds  is.  How  shall 
those  funds  be  invested?  This  seems  a  very  easy  prob- 
lem at  first  sight;  and  indeed  the  simple  process  of  in- 
vesting is  easy  enough.  To  invest  capital  funds  wisely 
and  to  the  best  advantage  for  the  future  of  the  corpora- 
tion, however,  is  a  task  that  requires  careful  thought  and 
foresight.  A  great  many  mistakes  are  made  just  at 
this  point.  The  causes  of  failure  of  a  great  many 
failed  corporations  may  be  traced  back  unquestionably 
to  errors  in  the  original  investment. 

Of  course,  each  corporation  has  its  own  peculiar  con- 
ditions to  meet  and  no  general  principles  can  be  laid 
down  that  will  take  the  place  of  keen  observation  and 
careful  reflection  over  all  factors  in  the  particular  situa- 
tion that  each  manager  faces.  Nevertheless,  there  are 
some  principles  with  regard  to  investment  of  capital 
funds  so  universal  and  some  fatal  errors  so  common  that 
a  short  study  of  the  problem  is  evidently  worth  while. 
Even  if  the  result  of  this  study  is  only  a  series  of  gener- 
alities, still  experience  shows  that  these  generalities  are 
worth  making  and  worth  keeping  constantly  in  view. 

154.  The  installment  method  of  getting  cash  as 
needed. — In  the  first  place,  a  new  corporation  as  a  rule 
does  not  require  all  of  the  capital  funds  that  will  be  nec- 

^84 


INVESTMENT  OF  CAPITAL  FUNDS  285 

essary  for  its  development  at  the  outset.  On  the  other 
side,  as  was  emphasized  in  connection  with  the  subject 
of  promotion,  the  corporation  managers  should  have  in 
sight  from  the  very  beginning  all  the  capital  funds  that 
they  are  likely  to  need;  for  an  effort  to  raise  additional 
capital  for  an  enterprise  that  is  onlyjialfjor  two-thirds 
completed,  and  not  on  a  paying  basis,  is^painful_and  fre- 
quently unavailing.  The  manager  or  promoter  of  the 
corporation,  then,  looks  for  some  method  of  reconciling 
these  conflicting  requirements. 

The  simplest  and  best  niethod,  from  the  corporation's 
standpoint,  is  to  obtain  subscriptions  before  the  new 
concern  is  started  for  more_than  enough  stocks  andjbonds^ 
to  carry  it  through  to  success,  but  tojiave  the^ash_f or 
these  securities  payablejnjnstall^^  This  method  is 

common  and  works  very  well  with  enterprises,  the  total 
capital  cost  of  which  can  be  accurately  estimated  in  ad- 
vance— such  enterprises,  for  instance,  as  the  erection  of 
an  ofBce  building  or  the  construction  of  a  railroad.  In 
such  cases  the  installments  may  be  certain  definite  per- 
centages due  at  days  fixed  in  advance,  say  10  per  cent 
when  the  corporation  is  organized,  25  per  cent  at  the 
expiration  of  three  months,  25  per  cent  at  the  end  of  six 
months,  20  per  cent  at  the  end  of  nine  months,  and  the 
remaining  20  per  cent  at  the  end  of  a  year.  In  this  way 
the  sale  of  securities  is  facilitated,  because  buyers  prefer 
usually  to  pay  in  installments,  and  the  corporation  gets 
its  funds  as  needed. 

The  case  is  quite  different,  however,  when  the  total 
amount  of  capital  funds  needed  cannot  be  foretold.  A 
corporation  may  be  formed,  for  instance,  to  open  up  a 
mine  or  construct  a  tunnel  or  start  a  magazine.  No- 
body can  foresee  absolutely  what  obstacles  the  under- 
ground work  of  the  mine  or  tunnel  will  encounter,  or 


286  CORPORATION  FINANCE 

how  quickly  the  magazine  will  "take"  with  the  reading 
public.  The  promoter  of  such  an  enterprise,  if  he  is 
honest  with  himself,  will  recognize  that  the  corporation 
perhaps  may  need  less  and  probably  will  need  a  great 
deal  more  capital  funds  than  he  anticipates.  In  order 
to  meet  this  situation  he  will,  if  he  can,  induce  people  to 
subscribe  capital  funds  to  an  amount  greater  than  will 
probably  be  needed,  issue  part-paid  stock  when  install- 
ments to  a  certain  amount,  say  50  per  cent,  have  been 
paid  and  make  the  rest  of  the  installments  payable  at 
the  option  of  the  corporation.  Thus  the  corporation 
can  get  all  the  funds  it  needs  and  at  the  same  time  does 
not  have  to  carry  large  sums  for  which  it  has  no  partic- 
ular use.  This  is  the  ideal  arrangement  for  such  a 
corporation. 

155.  Disadvantages  of  this  method. — Unfortunately 
this  plan  does  not  appeal  to  the^  average  stockholder. 
He  does  not  like  the  idea  of  being  liable  at  all  times^f  or 
_the  unpaid  installments,  particularly  as  the  calls  for 
additional  payments  in  many  such  enterprises  are  apt  to 
come  during  periods  of  financial  distress  at  the  very 
time  when  it  will  be  extremely  disagreeable  for  him  to 
meet  them.  Moreover,  in  large  corporations  such  an 
arrangement  gives  to  the  managers  of  the  corporation 
an  opportunity  for  manipulation  that  they  are  not  al- 
ways virtuous  enough  to  resist.  Take  the  case,  for  ex- 
ample, of  a  well-known  street  railway  company,  which 
may  be  recognized  by  some  of  our  readers,  but  whose 
name  it  would  be  improper  to  give  in  this  connection: 
This  company  has  a  very  large  amount  of  part-paid 
stock  outstanding,  the  remaining  installments  being  due 
and  payable  at  the  option  of  the  board  of  directors.  It 
is  strongly  suspected  that  the  board  on  several  occasions 
have  agreed  among  themselves  in  advance  to  issue  a  call 


INVESTMENT  OF  CAPITAL  FUNDS  287 

for  an  installment  and  have  thus  given  themselves  plenty 
of  time  to  accumulate  cash.  Then  the  call  has  been 
issued  and  the  installment  made  payable  at  a  very  early 
date,  so  as  to  make  it  difficult  for  most  of  the  stock- 
holders  to  meet  the  calL  The  result  naturally  has  been 
in  each  instance  that  considerable  amounts  of  thgjQ^art- 
paid  stock  were  throvi^n  on  the  market  and  bought  up  at 
"Sargainprices  byTEejdirectorsjindjthe^  With 

the  funds  received  from  the  installment  the  corporation 
has  been  in  position  to  put  its  property  in  good  condition 
and  show  excellent  earnings  for  a  year  or  two,  thus  al- 
lowing the  directors  to  sell  stock  at  high  prices.  After 
it  was  distributed  the  directors  have  issued  another  call 
and  have  repeated  the  milking  process.  Experiences 
like  this  have  made  buyers  of  securities  very  cautious Jn 
the  purchase  of  part-paid  stock.  Generally  speaking,  it 
is  a^difficult  thing  to  sell  any  stock  that  is  not  labeled 
*'full  paid  and  non-assessable." 

156.  ^Other  possime  methods. — It  follows  that  the 
managers  of  a  corporation,  the  needs  of  which  for  capi- 
tal funds  cannot  be  estimated  in  advance,  are  driven  to 
take  one  of  two  courses :  either  they  must  sell  at  the  be- 
ginning a  far  greater  amount  of  securities  than  will 
probably  prove  necessary,  and  put  their  idle  funds  to 
some  use  outside  the  original  purpose  of  the  corporation, 
or  else  they  must  trust  to  luck  that  they  will  be  able  to  sell 
more  securities  when  additional  capital  funds  are  needed. 
Neither  one  of  these  alternatives  is  free  from  serious 
objections. 

Here,  then,  is  the  first  great  problem  in  connection 

with  the  investment  of  capital  funds,  that  of  getting  the^ 

_fund&-when  and  if  they  prove  to  be  needed^    If  that 

problem  is  not  solved  in  just  the  right  manner,  either 

the  corporation  will  have  more  funds  on  hand  than  it 


S88  CORPORATION  FINANCE 

needs  and  its  rate  of  profits  on  stock  will  thereby  be 
diminished,^  else  it  will  not  have  enough  funds  and  its 
development  will  thereby  be  checked. 

157.  How  much  shall  be  invested  in  fixed  capital? — 
The  next  question  to  consider  is,  What  proportion  of  the 
capital  funds  shall  be  put  into  "fixed"  and  what  into 
*^orking"  capital?  The  distinctions  between  fixed, 
semi-fixed,  current  and  quick  assets  were  discussed  in 
Chapter  VII.  The  fixed  and  semi-fixed  assets  to- 
gether— those  assets,  in  other  words,  which  cannot  be 
readily  converted  into  cash — constitute  the  corporation's 
fixed  capital.  Working  capital  is  somewhat  different. 
It  consists,  not  of  the  current  assets,  but  of  the  difference 
between  current  assets  and  current  obligations^  In  other 
words,  it  consists  of  that  amount  of  current  assets  which 
is  not  furnished  by  trade  and  other  short-time  creditors 
and  by  temporary  bank  loans. 

The  amount  of  fixed  capital  required  by  any  corpora- 
tion depends,  of  course,  on_the  nature  of  its  operations. 
Industrial  and  mining  corporations  must  have  machin- 
ery; railroad  companies  must  have  track  and  rolling 
stock;  trading  companies  must  have  office  furniture  be- 
fore they  can  start  business.  The  necessary  total  of 
fixed  capital  is  not  always  so  great  as  it  appears  to  an 
outsider,  for  the  reason  that  in^most  enterprises  land, 
buildings  and  even  machinery  can  be  rented  to  better 
advantage  than  they  can  be  bought.  Accountants  rec- 
'bgnize  this  fact  and  are  in  the  habit,  in  estimating  the 
true  cost  of  production  in  a  manufacturing  establish- 
ment, of  charging  an  estimated  rent  for  the  land  and 
buildings  even  though  they  be  owned  in  fee  by  the 
corporation.  It  is  well  for  corporation  managers  to 
consider  this  possibility,  especially  in  starting  a  new 


INVESTMENT  OF  CAPITAL  FUNDS  289 

enterprise,  and  where  possible  avoid  the  investment  of 
large  sums  in  fixed  assets  until  after  the  success  of  the 
enterprise  is  assured. 

One  of  the  characteristics^  of  fixed  capitaj-is  that,  al- 
though it  may  be  essential  and  valuable  to  the  corpora- 
tion which  owns  it,  it  is  likely  to  have  very  Uttle  value^ 
if  put  on  the  market  f or  sala  Its  value  remains,  in 
'other  words,  only  so  long  as  the  concern  is  "going." 
Therefore,  the  smaller  the  proportion  of  a  corporation's 
capital  invested  in  fixed  assets^  ihe  better  off  it  is  in  case^ 
of^ailure  or  bankruptcy. 

158.  Forms  of  working  capital. — Working  capital 
may  take  any  or  all  of  four  forms : 

(l)^Cash,  either  on  hand  or  in  banks. 

(2)^  Bills  and  accounts  receivable. 

(3)  Raw  materials  and  finished  products  in  stock. 

(4)  Securities  of  other  corporations  held,  not  for 
control,  but  for  temporary  investment. 

As  an  illustration  take  the  following  table,  whicK 
shows  the  current  assets  and  current  liabilities  of  the 
United  States  Rubber  Company  for  the  fiscal  year  ended 
March  31,  1908,  compared  with  the  preceding  year  and 
the  working  capital,  or  excess  current  assets  over  current 
liabilities : 

CUEEENT   ASSETS. 

190T  1908 

Inventories    :. . .   $18,404,726  $13,533,169 

Cash    ,       2,061,401  2,723,380 

Bills  receivable 3,681,126  994,250 

Accounts  receivable 8,687,631  8,494,234 

Totals  ........  .|.  .r.,.: ,  $32,834,884         $25,745,033 

1—19 


290  CORPORATION  FINANCE 

CURRENT    LIABILITIES. 

Loans  and  notes  payable $  6,821,077  $  2,440,077 

Accounts  payable 737,384  362,634 

Due  General  Rubber  Co.  . . 7,269,441  7,164,111 

Reserve  for  discount , 872,989  874,735 

Totals $15,700,891         $10,841,557 

Working  capital $17,133,993         $14,903,476 

159.  How  much  working  capital  shall  he  carried? — 
The  amount  of  actual  cash^eeded  by  a  corporation 
varies  with  the  size  of  its  pay-roll  and  other  current 
demands  for  cash,  with  the  amount  and  character  of  its 
accounts  payable  considered  in  connection  with  its  ac- 
counts receivable,  with  the  discounts  that  it  may  obtain 
on  purchases  by  making  cash  payments,  and  with  its 
facilities  for  securing  temporary  loans.  The  force  of 
these  considerations  must  be  estimated  by  the  corpora- 
tion managers.  Obviously  there  is  a  waste^in  carrying 
unnecessarily  J_aTge  bank  balances  *,  if  any  interest  is 
received  on  such  balances,  it  will  not  usually  run  higher 
than  2  per  cent.  Oi\  the  other  hand,  every  corporation 
naturally  desires  to  stand  well  with  banks  and  will  carry 
large  enough  balances  to  make  its  deposits  worth  having. 
Otherwise,  the  corporation  in  times  of  difficulty  may 
turn  to  banks  in  vain  for  temporary  assistance. 

The  amount  of  accounts  receivable  cannot  be  de- 
termined by  the  financial  management  of  a  corporation, 
but  depends  on  the  volume  of  sales,  on  the  custom  of  the 
trade  as  regards  payment  and  on  the  efficiency  of  the 
credit  department  in  granting  credits  and  in  making 
collections. 

The  amount  of  finished  products  and  raw  materials 
on  hand  is  directly  determined,  of  course,  by  the  operat- 
ing department  of  each  company.  Nevertheless,  the 
executive  heads  of  the  company  should  and  usually  do 


INVESTMENT  OF  CAPITAL  FUNDS  291 

exercise  some  discretion  in  this  regard,  particularly  with 
a  view  to  reducing  the  amount  of  working  capital  thus 
invested  to  a  minimum.  A  great  many  manufacturing 
corporations,  on  account  of  improper  purchasing  and 
accounting  methods,  are  wasteful  in  this  regard.  Care- 
ful perpetual  inventories  of  goods  in  stock  will  often 
make  it  possible  to  buy  and  sell  more  closely  without 
interfering  in  the  least  with  the  operating  efficiency  of 
the  business.  Although  this  is  a  topic  which  belongs 
rather  to  organization  and  accounting  than  to  finance, 
its  importance  to  a  corporation's  financial  management 
should  not  be  overlooked. 

160.  The  "practice  of  large  corporations, — The  fol- 
lowing compilation  made  by  the  Wall  Street  Journal 
is  of  particular  interest  in  that  it  shows  the  practice  with 
regard  to  working  capital  of  the  largest  and  best-man- 
aged corporations, 

A  study  of  reports  of  the  leading  industrial  companies  shows 
that  the  United  States  Steel  Corporation  takes  the  lead  in  work- 
ing capital,  with  the  Standard  Oil  Co.  second,  the  International 
Harvester  Co.  third  and  the  General  Electric  Co.  fourth. 

Including  sinking  and  reserve  fund  assets  invested  in  securi- 
ties, amounting  to  $32,442,400,  the  working  capital  of  the  U. 
S.  Steel  Corporation  Is  $261,789,885. 

The  International  Harvester  Co.,  aside  from  the  Standard 
Oil  Co.,  probably  has  a  larger  working  capital  to  gross  business 
than  any  other  corporation  of  consequence.  Its  working  capi- 
tal as  of  December  31,  1907,  aggregated  $77,087,811,  while  its 
gross  business  amounted  to  only  $78,206,890. 

The  General  Electric  Co.  also  shows  up  well  from  the  stand- 
point of  working  capital,  reporting  $61,235,724  on  January 
31  last,  compared  with  its  gross  business  of  $70,977,168. 

The  following  table  gives  the  working  capital  of  several 
of  the  prominent  Industrial  companies,  together  with  gross  busi- 
ness and  capitalization  for  their  respective  fiscal  years : 


292  CORPORATION  FINANCE 

Company  Gross  Working  Capital 

Year  Ended  Business  Capital  Stock 

United  States  Steel 

Dec.  31,  1907  $757,014,767*$261,789,885  868,583,600 
Internat.  Harvester 

Dec.  31,  1907  78,206,890  77,087,811  120,000,000 
General  Electric 

Jan.  31,  1908  70,977,168  61,235,724  65,167,400 
Westh.  Elec.  Mfg. 

Mch.  31,  1907      33,026,240       19,061,807  24,969,000 

Lack.  Steel 

Dec.  31,  1907       33,011,410       13,881,340  34,721,400 

Republic  I.  &  Steel 

June  30,  1907       31,229,423         6,720,000  47,607,900 

Beth.  Steel 

Dec.  31,  1907       15,000,000         7,434,573  29,770,000 

Am.  Steel  Foundries 

July  31,  1907       19,463,521         4,834,843  17,184,000 

Midvale  Steel 

Oct.   31,  1907        .., . ..         1,804,929  750,000 

Allis-Chalmers 

June  30,  1907 .,.   12,522,074    35,790,000 

Cambria  Steel  Co. 

Dec.  31,  1907       ...,.., 14,597,865  45,000,000 

Total $730,970,851  $1,389,570,450 

The  above  figures  show  that  the  twelve  companies  in  question 
are  well  fortified  with  working  capital.  The  aggregate  working 
capital  stands  at  $730,970,851  as  compared  with  total  stock  cap- 
itahzation  of  $1,389,570,450. 

The  figures  given  above  indicate  that  the  compamies  in  ques- 
tion are  in  a  strong  position  to  weather  the  depression  through 
which  they  are  now  passing. 
*  Includes  sinking  and  reserve  fund  assets  amounting  \m  $32,442,401, 


INVESTMENT  OF  CAPITAL  FUNDS         293 

To  invest  workingjeapital  to  any  considerable  amount 
in^e  securitie&-Qf_other  corporations  is  not  a  very  com- 
mon or  commendable  practice.  It  is  justifiable  only  in 
those  companies  that  have  great  fluctuations  in  demands 
for  casb^^nd  that  cannot  secure  fair  interest  on  bank 
balances.  The  buying  and  selling  of  securities  is  no 
part  of  the  business  of  any  corporations  except  the  few 
which  are  distinctly  organized  for  that  purpose.  Prof- 
its that  are  derived  from  this  source  are  justly  regarded 
as  speculative  and  highly  uncertain. 

161.  Factors  that  affect  working  capital. — Consider- 
ing the  situation  as  a  whole  the  proportion  of  working 
to  fixed  capital  in  any  business  may  be  said  to  depend 
upon  five  factors,  as  follows: 

(1)  Volume  of  business. 

(2)  The  regularity  of  supply  of  whatever  raw  ma- 
terials are  used  and  the  savings  which  may  be  effected 
by  buying  raw  materials  in  large  quantities.  If  it  is 
necessary  for  the  corporation  to  pick  up  large  batches 
of  raw  materials  at  irregular  periods  in  order  to  get  ad- 
vantageous terms,  of  course  the  working  capital  must 

)e  correspondingly  increased,  for  two  reasons :  first,  be- 
xause  larger  amounts  of  raw  materials  must  be  carried 
stock  than  would  otherwise  be  necessary;  second,  be- 
Luse  larger  bank  balances  must  be  maintained  in  order 
meet  these  irregular  demands. 

(3)  Regularity  of  the  demand  for  the  product  of  the 
corporation.  The  same  considerations  apply  here  as 
^ere  named  in  connection  with  the  preceding  factor. 

(4)  Customs  of  payment  in  the  business.  Some 
manufacturing  corporations  normally  buy  on  90  days' 
time  and  sell  on  30  days'  time.  This  arrangement  makes 
it  possible  to  meet  the  accounts  payable  out  of  accounts 


294^  CORPORATION  FINANCE 

receivable  and  lessens  the  necessary  amount  of  working 
capital. 

(5)  The  length  of  time  required  to  turn  out  the 
finished  product.  It  takes  three  or  four  years  normally 
to  build  a  big  steam  vessel.  During  that  period  the 
ship-building  corporation  will  necessarily  pay  out  large 
sums  for  lumber  and  materials  and  a  big  working  capi- 
tal, therefore,  will  be  necessary.  The  same  remark  ap- 
plies to  all  concerns  in  which  the  period  of  manufacture 
is  lengthy. 

There  is  one  great  industry  of  the  United  States 
which  can  usually  get  along  with  a  very  small  proportion 
of  working  capital,  namely,  _  railroad^peration.  The 
prime  reason  is  that  the  railroads  are  manufacturing  a 
commodity,  that  is,  transportation,  which  is  continually 
in  demand  and  which  is  paid  for  ordinarily  as  soon  as  it 
is  produced.  There  are  no  outlays  to  speak  of  for  cur- 
rent raw  materials ;  the  only  raw  materials  that  railroads 
use  are  for  fixed  assets  and  may  be  regarded  as  part  of 
the  cost  of  securing  fixed  capital. 

162.  The  working  capital  of  the  Pennsylvania  Rail- 
road,— Even  among  railroads  there  may  be  exceptional 
circumstances  which  make  necessary  large  working 
capitals.  The  Pennsylvania  Railroad,  for  example,  in 
the  early  part  of  1909  was  completing  its  inmiense  ter- 
minal improvements  in  and  near  New  York  City.  In  a 
sense  it  was  engaged  in  the  contracting  business  on  a 
great  scale,  for  it  was  building  tracks,  tunnels  and  sta- 
tions. Therefore,  it  needed  temporarily  as  much  work- 
ing capital  as  a  manufacturing  corporation  should  have. 
Making  a  strict  classification  of  current  assets  and 
liabilities,  the  Pennsylvania  Railroad's  cash  position  at 
the  end  of  1908  compares  with  its  position  twelve  months 
before  as  follows: 


INVESTMENT  OF  CAPITAL  FUNDS  295 

CURRENT  ASSETS. 

1908  1907  Changes 

Cash   $56,035,898  $37,385,673  Inc.  $18,640,225 

Bills  &  accts.  rccv 14,294,080  18,069,840  Dec.     3,775,860 

Cash  assets   $70,319,978  $55,455,613  Inc.  $14,864,365 

CURRENT  LIABILITIES. 

Payrolls  &  vouch $14,227,369  $20,226,164  Dec.  $  5,998,795 

Int.  accrued,  etc 3,231,248  2,875,982  Inc.         355,266 

Miscellaneous    4,211,496  3,966,996  Inc.         244,500 

Current  liabilities    $21,670,113  $27,069,142  Dec.  $  5,399,029 

Excess  cur.  assets  48,649,865  28,386,471  Inc.    20,163,394 

This  makes  the  company's  net  free  capital,  subject  to 
the  company's  need  of  money  to  carry  on  its  everyday 
business  of  transportation,  more  than  $48,000,000  and 
$20,000,000  in  excess  of  what  it  had  been  the  year  before. 
The  other  assets,  not  to  be  classed  as  quick  items  but  more 
or  less  subject  to  liquidation  in  time,  and  deferred  and 
contingent  liabilities,  compare  as  follows: 

DEFERRED  AND  CONTINGENT  ASSETS. 

1908  1907                    Change* 
Due  on  N.  &  W.  &  C.  & 

RO.  stocks    $15,492,685  $15,492,685                     
sans   for  cons.,   &c 12,403,834  18,412,493  Dec.  $  6,008,659 
uc  from  controlled  com- 
panies           3,159,784  462,218  Inc.      2,697,566 
aterials  on  hand 10,449,483  15,929,925  Dec.     5,480,442 

Sink,   fund  assets    8,148,208  7,772,627  Inc.         375,581 

Total    $49,653,994  $58,069,948  Dec.  $  8,415,954 

DEFERRED  AND  CONTINGENT  LIABILITIES. 

Car  trusts  chgd  out $  2,043,803  $  1,424,871  Inc.  $     618,929 

Taxes  chgd  out    2,731,109  3,023,197  Dec.        292,088 

Due  Penna.  Co 2,290,897  Dec.     2,290,897 

Extr.   exp.    fund... 2,500,000  Dec.     2,500,000 

Sinking  fund  liab 10,339,057  9,815,956  Inc.          523,101 

Total    $15,113,966  $19,054,921  Dec.  $  3,940,955 

Excess  def.  &  con.  assets  $34,540,028  $39,015,027  Dec.  $  4,474,999 


£96  CORPORATION  FINANCE 

163.  General  conclusions  as  to  working  capital, — 
Many  other  industries,  particularly  those  manufacturing 
stable  articles  of  trade,  require  a  comparatively  small 
proportion  of  working  capital.  On  the  other  hand,  there 
are  lines  of  business,  such,  for  instance,  as  publishing, 
in  which  practically  no  fixed  capital  (office  furniture, 
perhaps,  excepted)  is  needed.  This  is  true  more  or  less 
of  all  trading  corporations. 

As  was  intimated  at  the  beginning  of  this  chapter,  the 
principles  herein  laid  down  are  of  a  very  broad  and 
general  nature  and  can  be  successfully  applied  only  by 
keen  intelligence.  Perhaps  the  chief  practical  con- 
clusion is  that  the  most  careful  thought  must  be  given 
to  securing  a  proper  proportion  of  working  capital.  No 
matter  how  valuable  the  fixed  assets  of  a  corporation 
may  be,  if  it  does  not  have  all  the  funds  necessary  to 
transact  current  business  and  to  meet  current  obligations, 
it  will  inevitably  prove  a  failure.  Right  here  is  where 
most  of  the  mistakes  and  failures  of  the  early  stages  of 
corporate  management  occur.  Managers  trust  that  the 
current  sales  will  take  care  of  current  expenses;  when 
the  inevitable  hitch  occurs  they  have  no  other  resources 
to  use  and  the  corporation  suddenly  plunges  into  the 
quicksands  of  financial  trouble  and  discredit.  This 
problem  of  providing  sufficient  working  capital  will 
crop  out  again  when  we  come  to  consider  the  causes  of 
corporate  insolvency. 


CHAPTER  XXI 


DISPOSITION  OF  GROSS  EARNINGS 

164.  Determination  of  income. — The  ordinary  form 
of  income  statement  of  a  corporation  is  somewhat  as 
follows : 


(a 
(b 

(c 
(d 
(e 
(f 
(g 
(h 
(i 
(J 
(k 

(1 
(m 


Gross  earnings  from  operation  or  manufacture. 

Deduct  operating  or  manufacturing  ex- 
penses. 
Net  earnings  from  operation  or  manufacture. 

Add  income  from  other  sources. 
Total  income. 

Deduct  taxes. 
Balance  applicable  to  fixed  charges. 

Deduct  interest. 

Deduct  rentals. 

Deduct  sinking  fund  and  other  charges. 
Balance  applicable  to  dividends  and  surplus. 

Deduct  dividends. 
Surplus  from  the  year's  operations. 


It  goes  without  saying  that  each  corporation  has  its 
own  methods  of  stating  accounts  and  that  there  are 
many  variations  from  this  standard  form.  The  essen- 
tial items,  however,  are  those  stated  above.  It  would 
be  well  for  the  reader  to  study  with  some  care  the  income 
accounts  of  large  corporations  which  are  made  public 
from  time  to  time  and  which  are  printed  in  the  financial 
columns  of  all  metropolitan  newspapers.  If  any  of  the 
items  given  above  are  not  altogether  clear,  the  reader 

897j 


298  CORPORATION  FINANCE 

should  turn  to  the  volume  on  Theory  and  Practice  of 
Accounting  and  go  over  the  explanation  there  given 
of  the  income  statement. 

The  relations  between  accounting  and  finance  are  so 
close  that  a  fair  understanding  of  the  basic  principles 
of  accounting  is  necessary  in  order  to  deal  intelligently 
with  the  problems  of  financial  management.  In  what 
is  said  below  in  reference  to  each  of  the  items  in  the 
income  account  it  will  be  assumed  that  the  reader  is 
familiar  with  accounting  terms  and  with  the  elements 
of  accounting  practice. 

165.  Honesty  in  stating  gross  earnings, — Perhaps 
the  only  comment  needful  on  the  first  item  "gross 
earnings"  is  that  it  should  be  honestly  stated.  This 
remark  is  trite  enough,  and  yet  not  uncalled  for.  A 
great  many  corporation  managers  are  in  the  habit  of 
including  in  their  gross  earnings  sales  that  have  been 
made  to  parties  of  doubtful  credit  which  are  represented 
merely  by  accounts  receivable  that  are  probably  bad. 
In  the  case  of  holding  companies  it  is  not  so  uncommon 
as  it  should  be  to  include  in  the  gross  earnings  sales 
made  from  one  company  to  another  in  the  combination. 
Of  course  this  is  simply  a  juggling  with  figures.  A 
still  more  flagrant  instance  of  dishonesty  was  disclosed 
by  Mr.  Stephen  Little,  an  accountant  of  wide  reputa- 
tion, who  in  1894  was  called  upon  to  investigate  the 
condition  of  the  insolvent  Atchison,  Topeka  and  Santa 
Fe  Railroad  Company.  Mr.  Little  found  that  the 
railroad  had  paid  out  millions  of  dollars  in  rebates  to 
shippers  which  had  not  been  deducted  from  its  state- 
ment of  gross  earnings. 

166.  What  are  operating  expenses? — Operating  ex- 
penses are  also  often  grossly  misstated,  although  in  this 
instance  the  fault  is  apt  to  be  due,  not  so  much  to  the 


DISPOSITION  OF  GROSS  EARNINGS  299 

dishonesty  of  the  corporation  managers,  as  to  their 
ignorance  of  correct  accounting  principles.  The  oper- 
ating expenses  ought  always  to  include  not  only  the 
actual  expenditures  for  raw  materials,  labor  and  current 
repairs,  but  also  a  liberal  allowance  for  anticipated  re- 
pairs and  renewals  and  for  depreciation. 

Repairs  in  the  early  years  of  a  corporation's  activities 
are  seldom  as  great  a  burden  as  in  later  years.  Ac- 
countants figure  that  most  manufacturing  machines 
,  will  show  a  rising  percentage  of  necessary  repairs  each 
I  year  for  the  first  five  to  ten  years  of  its  existence  and 
after  that  a  fairly  steady  ratio  will  be  maintained.  Now 
it  is  evident  that  unless  some  allowance  is  made  during 
the  first  few  years  for  the  rise  in  this  item  during  the  fol- 
lowing years,  a  misleading  statement  of  operating  ex- 
penses will  be  presented. 

Corporations  differ  greatly  in  their  handling  of 
charges  for  renewals  of  machinery  and  equipment. 
Many  of  them  figure  that  the  new  machines  they  buy 
are  additions  to  their  capital  and  therefore  should  not 
be  charged  against  the  income  account  at  all.     If  the 

tew  machine,  however,  replaces  to  any  extent  an  old 
lachine,  this  reasoning  is  obviously  incorrect.  Only 
he  difference  between  the  value  of  the  old  and  the  value 
f  the  new  machine  could  properly  be  charged  to  capital 
account.  Conservative  corporations  in  this  country, 
railroads  particularly,  are  in  the  habit  of  charging  the 
whole  cost  of  their  new  equipment,  as  a  rule,  as  a  part 
of  operating  expenses.  The  English  railroad  practice, 
on  the  other  hand,  is  to  charge  the  whole  expense  to 
capital  and  to  raise  new  capital  funds  to  meet  it.  We 
shall  have  occasion  to  consider  this  point  further  in  con- 
nection with  "betterment  expenses." 

167.  Necessity  for  depreciation  reserves, — The  sub- 


300  CORPORATION  FINANCE 

ject  of  depreciation  is  too  large  and  important  to 
receive  full  consideration  in  this  place;  a  more  extended 
treatment  will  be  found  in  the  volumes  on  accounting. 
As  the  desirability  of  allowing  properly  for  deprecia- 
tion ought  to  be  indelibly  impressed  on  the  mind  of 
every  person  interested  in  corporation  management, 
however,  some  brief  remarks  on  the  subject,  even  at  the 
risk  of  reiteration,  are  worth  making  here. 

There  are  three  general  causes  of  depreciation,  as 
follows : 

(a)  Failure  to  keep  property  in  first-class  working 
condition. 

(b)  The  gradual  breaking  down  of  property  in 
spite  of  all  that  may  be  done  to  keep  it  in  good  condition. 

(c)  Most  important  of  all,  obsolescence  or  the  im- 
pairment of  value  because  of  new  inventions  and 
processes. 

It  is  difficult  for  anyone  not  directly  familiar  with 
modern  manufacturing  enterprises  to  conceive  of  the 
rapidity  with  which  changes  in  mechanical  methods 
follow  each  other.  Each  important  change  is  apt  to 
make  necessary  a  general  revision  of  all  the  machinery 
and  processes  of  manufacture.  In  the  intense  com- 
petition between  industries,  no  concern  that  allows  itself 
to  fall  behind  in  the  race  to  install  the  latest  and  most 
economical  devices  will  long  be  able  to  survive.  Ameri- 
can manufacturers  have  long  been  famous  for  the  vigor 
and  fearlessness  with  which  they  adopt  new  machinery 
and  processes,  even  though  the  change  may  make  almost 
worthless  the  expensive  equipment  that  had  previously 
been  installed.  The  Carnegie  Steel  Company,  it  is  said, 
time  after  time,  has  relentlessly  sent  to  the  scrap  heap 
costly  machines  and  even  whole  plants  that  were  found 
to  be  inferior  to  new  inventions. 


DISPOSITION  OF  GROSS  EARNINGS  301 

This  policy  certainly  pays  in  the  long  run,  as  the 
striking  success  of  the  Carnegie  Steel  Company  shows. 
Where  products  are  being  turned  out  in  great  quantities, 
a  very  slight  saving  in  the  cost  of  producing  each  unit 
may  prove  to  be  the  margin  between  bankruptcy  and 
prosperity.  Yet,  though  the  policy  is  to  be  praised  and 
followed,  it  must  not  be  forgotten  that  it  involves  large 
losses  for  the  time  being  whenever  old  machines  are 
superseded  by  new.  These  losses  ought  to  be  foreseen 
and  provided  against  when  the  first  steps  of  an  enter- 
prise are  taken.  The  only  possible  means  of  so  do- 
ing is  to  charge  as  part  of  tlie  operating  expenses  every 
year  a  liberal  sum  for  depreciation — a  sum  that  will 
take  care,  not  merely  of  decay  due  to  old  age  and  lack 
of  repair,  but  of  obsolescence  as  well. 

Anything  like  a  scientific  treatment  of  depreciation 
has  unfortunately  been  conspicuously  absent  from  the 
accounts  of  most  American  corporations.  Manufac- 
turers have  been  too  willing  to  make  rough  guesses 
where  fairly  exact  scientific  deductions  might  have  been 
drawn.     Electric  and  steam  railroads  have  uniformly 

I  declined  to  make  any  allowance  whatever  for  deprecia- 
tion on  the  ground  that  the  value  of  their  franchises  is 
steadily  rising  and  that  this  is  sufficient  to  offset  what- 
ever depreciation  of  their  property  is  going  on.  There 
is  a  certain  amount  of  truth,  to  be  sure,  in  this  assertion ; 
yet  it  reveals  a  woefully  careless  habit  of  thought. 
Such  slap-dash  methods  fortunately  are  now  being 
eradicated,  so  far  as  interstate  steam  and  electric  lines 
are  concerned,  through  the  control  over  their  accounts 
now  exercised  by  the  Interstate  Commerce  Commission. 
Recent  rulings  of  the  Commission  have  very  properly 
made  it  obligatory  on  railroads  to  form  as  accurate 
estimates  as  they  can  of  the  annual  depreciation  of  their 


S02  CORPORATION  FINANCE 

property  and  to  set  aside  every  year  as  part  of  operating 
expenses  an  adequate  depreciation  charge. 

To  avoid  any  possible  misunderstanding  by  those 
who  may  not  be  familiar  with  accounts,  it  may  be  well 
to  state  at  this  point  that  depreciation  reserves,  so  called, 
are  not  sums  set  apart  and  invested  outside  of  the  prop- 
erty, but  are  merely  the  total  charges  against  gross 
earnings  over  a  series  of  years  on  account  of  deprecia- 
tion. The  depreciation  reserves  are  not  separable  from 
other  capital  funds  invested  in  the  business  except  as 
a  matter  of  accounting. 

168.  Income  from  other  sources  and  deductions, — 
We  have  now  reached  in  our  income  statement  the  item 
"net  earnings  derived  from  operation."  To  these 
earnings  should  be  added  "income  from  other  sources." 
In  order  to  make  the  income  account  a  clear  and  ac- 
curate statement  of  results  of  the  year's  operations, 
it  is  very  important  that  this  "income  from  other 
sources"  should  be  stated  separately  and  not  confused 
with  "net  earnings  from  operation";  otherwise  the  cor- 
poration managers  will  be  claiming  credit  for  returns 
that  are  quite  distinct  from  the  company's  own  opera- 
tion. Income  from  other  sources*  includes  dividends 
on  the  stocks  of  subsidiary  and  other  companies,  inter- 
est on  the  bonds  of  such  companies,  interest  on  bank 
deposits,  rentals  of  property  owned  by  the  corpora- 
tion and  not  used  in  its  own  operations,  and  other 
items  of  that  nature.  Such  returns  are  frequently 
temporary  or  irregular,  in  which  case,  in  order  to  make 
the  situation  clear,  they  ought  to  be  specifically  named 
in  the  income  statement. 

We  now  deduct  taxes  which,  it  will  be  noted  in  our 
model  income  statement,  should  not  be  included  under 
fixed  charges.     There  is  some  difference  of  opinion  on 


DISPOSITION  OF  GROSS  EARNINGS         303 

this  point.  It  is  not  a  matter  of  sufficient  importance, 
however,  to  be  worth  arguing  over.  The  view  here 
taken  is  that  taxes  are  variable  in  amount,  and  are  not, 
therefore,  on  the  same  basis  as  the  regularly  recurring 
fixed  charges. 

As  to  the  nature  of  interest  and  rentals,  little  need 
here  be  said.  Sinking  funds  have  been  sufficiently 
treated  for  our  purpose  in  another  place. 

The  deduction  of  fixed  charges  leaves  as  a  balance 
the  income  applicable  to  dividends  and  surplus.  Pre- 
ferred dividends,  as  have  previously  been  explained,  are 
classified  as  cumulative  and  non-cumulative.  Cumula- 
tive dividends,  to  the  corporation  managers,  are  often 
extremely  disagreeable  things.  They  are  not  so  bad  as 
interest  charges,  for  they  may  be  deferred  as  often  as 
necessary.  On  the  other  hand,  the  fact  that  they  are 
cumulative  makes  them  pile  up  at  an  alarming  rate, 
and  in  the  course  of  a  very  few  years,  if  they  are  not 
paid,  they  become  a  charge  ahead  of  the  common  stock 
that  makes  common  stock  dividends  seem  an  unattain- 
able vision.  For  the  best  interests  of  common  stock- 
holders, therefore,  it  is  usually  very  desirable  to  pay 
cumulative  preferred  dividends  regularly.  If  a  shrink- 
age in  profits  makes  a  temporary  lapse  necessary,  the 
lost  ground  should  be  regained  at  the  first  opportunity. 

169.  How  much  shall  he  paid  out  in  dividends. — The 
next  question  to  consider  in  disposing  of  the  earnings 
of  a  corporation  is.  How  much  shall  be  paid  out  in  non- 
cumulative  and  in  common  dividends.  Mr.  Thomas 
F.  Woodlock  has  well  said  that  the  payment  of  dividends 
is  the  only  absolutely  non-productive  expenditure  that 
an  honest  corporation  makes.  This  may  sound  like  a 
meaningless  paradox,  but  it  is  literally  true.  So  far  as 
the  corporation  itself  is  concerned,  whatever  is  paid  out 


304  CORPORATION  FINANCE 

in  dividends  is  a  total  loss.  On  the  other  hand,  it  is 
also  true  that  the  only  reason  for  the  corporation's  ex- 
istence is  that  it  may  pay  dividends  to  the  stockholders. 
There  is  a  conflict  of  interest  here  evidently  and  often 
a  strong  conflict  of  opinion  between  the  managers  of 
a  corporation  and  the  stockholders  as  to  whether 
dividends  should  be  paid  or  not.  In  the  next  chapter 
some  striking  examples  will  be  cited. 

Assuming  that  a  corporation  has  a  balance  for  the 
year  applicable  to  dividends  and  surplus,  and  that  all 
persons  concerned  are  agreed  that  some  dividends  should 
be  paid,  the  question  takes  the  form.  How  large  an 
amount  shall  be  thus  distributed  to  stockholders?  The 
first  and  most  natural  answer  to  this  question  is  that  all 
the  profits  of  each  year  belong  to  the  stockholders  and 
should  be  paid  out  in  dividends;  and  this  answer  is 
deemed  entirely  satisfactory  by  many  intelligent  people. 
The  English  corporations  almost  invariably  follow  this 
practice,  and  some  important  American  corporations 
as  well.  The  New  York  Central  Railroad  Company, 
for  instance,  has  for  many  years  paid  out  in  dividends 
each  year  almost  all  the  net  earnings  of  the  year. 

There  are  two  distinct  disadvantages  in  this  practice : 
First,  it  does  not  permit  the  corporation  to  create  a 
surplus  of  any  considerable  size;  second,  it  makes  the 
dividend  rate  irregular.  The  first  disadvantage  will  be 
more  fully  discussed  in  Chapter  XXIII.  The  second 
disadvantage  is  of  great  importance  and  calls  for  some 
explanation. 

170.  Variability  of  profits. — In  all  lines  of  business 
the  profits  necessarily  vary  from  year  to  year.  This  is 
true  because  all  the  factors  which  enter  into  and  de- 
termine profits  are  variable.     These  factors  are: 


DISPOSITION  OF  GROSS  EARNINGS  305 

(a)  Volume  of  sales. 

(b)  Prices  obtained. 

(c)  Prices  of  raw  materials. 

(d)  Wages. 

In  no  line  of  business  is  the  volume  of  sales  the  same 
from  year  to  year  and  in  no  line  even  where  the  general 
trend  is  upward,  can  the  volume  be  expected  to  increase 
steadily  and  regularly.  Some  fair  degree  of  regularity, 
to  be  sure,  can  be  attained  in  the  cases  of  large  public 
service  corporations,  such  as  waterworks,  street  railways 
and  steam  railroads,  that  deal  with  great  masses  of 
people.  Even  here  there  are  sometimes  surprising  fluc- 
tuations. In  most  lines  of  industry,  prices  are  very 
unstable  and  show  big  variations  from  year  to  year.  In 
general  it  may  be  said  that  those  industries  have  the 
most  regular  prices  and  volume  of  sales  which  are  con- 
cerned with  the  necessities  of  life;  and  the  further  you 
get  away  from  those  necessities,  the  more  violent  are 
the  fluctuations  in  those  two  items. 

To  make  these  statements  more  definite  let  us  examine 
the  records  of  some  of  the  leading  industrial,  street  rail- 
road and  steam  railroad  companies  during  the  year  of 
depression,  1908.  The  following  gives  the  percentage 
of  production  of  the  leading  industrial  companies,  com- 
pared with  normal: 

United  States  Steel  Corporation 60 

Republic  Iron  and  Steel  .  . .  ., 90 

Lukens  Iron  &  Steel 60 

Corn  Products  Refining  . 75 

Standard  Oil  . .  .  95 

General  Electric i 60 

Westlnghouse   , 60 

Pennsylvania  Steel 60 

Maryland  Steel 60 

1—20 


306  CORPORATION  FINANCE 

Jones  &  Laughlin 55 

Amalgamated  Copper 100 

National  Lead • 95 

American  Smelting  &  Refining 80 

Sloss-Sheffield  Steel  &  Iron 80 

International  Paper 70 

United  States  Rubber 75 

Allis-Chalmers    , 65 

American  Can  .  .,. .  . . 75 

American  Car  &  Foundry  .  ., ., 35 

Pressed  Steel  Car  . 20 

Railway  Steel  Spring 75 

American  Locomotive 40 

Bethlehem  Steel  Corporation 50 

International  Harvester ; 100 

United  States  Realty  &  Improvement 100 

Orders  for  new  railway  equipment  in  1908  were  less 
than  40  per  cent  of  those  received  during  1907  and 
hardly  20  per  cent  of  orders  booked  in  the  big  rush  of 
business  in  1905.  The  course  of  new  business  during 
the  last  four  years  may  be  gathered  from  the  following 
comparison : 

Year  Loco,  Orders     Fgt.  Car  Orders 

1908 1,182  62,700 

1907 3,282  151,700 

1906 5,642  310,315 

1905 6,265  341,315 

In  striking  contrast  is  the  record  of  the  following 
railroad  and  street  railway  companies.  Notice  partic- 
ularly the  small  fluctuations  in  the  street  traffic  in  large 
cities.  The  decrease  in  street  railway  gross  earnings 
was  less  than  1  per  cent  and  in  steam  railroad  gross 
earnings  about  19  per  cent. 


DISPOSITION  OF  GROSS  EARNINGS  307 

ELECTRIC  STREET  RAILWAYS. 
Company  and  Period  1908  1907  Decrease, 

Boston,  May-July   $  3,596,000  $  3,623,000  $  27,000 

Mass.  Elec,  Apr-June   1,995,842  1,924,333  *71,509 

Chicago  Rwys.,  Mch.-May   ....       2,625,533  2,574,324  *51,209 

Twin  City,  Apr.-June   1,474,389  1,492,671  18,283 

United  St.  Louis,  Mch.-May...       2,645,364  2,735,406  90,042 

Detroit  United,  Mch.-May 1,675,042  1,675,743  701 

Total    $14,012,170  $14,025,477  $13,307 

*  Increase. 

STEAM  RAILROADS. 
Company  and  Period  1908  1907  Decrease. 

Lake  Shore,  April-June $  9,182,851  $11,160,400  $  1,977,549 

New  Haven,  April-June 10,913,741  12,670,010  1,756,269 

Pennsylvania,   Jan.-Mch 31,375,489  37,203,589  5,828,100 

Louis.  &  Nash.,  Feb.-Apr.  . . .     10,073,862  12,012,701  1,938,839 

Missouri  Pac,  Feb.-Apr 9,467,500  11,927,824  2,460,324 

Boston  &  Maine,  Apr.-June..       8,836,556  10,499,302  1,662,746 

Total    $79,849,999  $95,473,826  $15,623,827 

The  explanation  of  the  different  manner  in  which  the 
street  railways  and  steam  railroads  have  fared  is  largely 
to  be  found  in  the  different  character  of  their  traffic. 
Street  railway  gross  is  95  per  cent  derived  from  pas- 
senger receipts,  while  from  65  to  70  per  cent  of  railroad 
gross  is  realized  from  freight;  and  in  periods  of  uni- 
versal curtailment  freight  earnings  quickly  feel  the 
depression. 

Even  with  an  absolutely  invariable  volume  of  sales 
and  level  of  prices  any  industry  would  still  be  subject 
to  great  variations  in  profits  by  reason  of  changes  in 
raw  material  prices  and  in  wages.  This  statement  is 
obvious  enough  without  any  elaboration.  It  should  be 
remarked  that  the  amount  of  wages  paid  out  is  not  de- 
pendent altogether  on  the  nominal  rate  of  wages,  but 
also  to  a  great  extent  on  the  efficiency  of  labor.  When 
times  are  good  and  sales  in  all  lines  are  heavy,  it  becomes 


308  CORPORATION  FINANCE 

necessary  to  employ  workingmen  of  an  inferior  grade, 
who  in  bad  times  are  always  "out  of  a  job."  Taking 
on  such  men  means  a  great  reduction  in  the  average 
efBciency  of  labor  and  in  economy  of  production. 

171.  Regularity  of  dividends  desirable, — ^We  are 
safe  in  saying  then  that  great  fluctuations  in  profits 
are  inevitable  in  most  lines  of  business  and  cannot  be 
altogether  avoided,  even  by  the  large  public  service 
corporations  which  furnish  the  necessities  of  life.  It 
follows  that  if  all  the  earnings  each  year  are  paid  out 
in  dividends,  the  rate  of  dividends  will  fluctuate — in 
many  cases  fluctuate  violently.  The  reader  may  per- 
haps ask  at  this  point.  Why  not  let  them  fluctuate?  Let 
the  stockholders  in  a  corporation  take  their  profits  as 
they  are  earned,  just  as  the  owner  of  an  individual  busi- 
ness or  partner  in  a  firm  would  do. 

The  answer  to  this  question  is  that  stock,  and  espe- 
cially the  stock  of  large  corporations,  is  widely  held  by 
people  of  all  classes  who  are  not  in  touch  with  business 
aff*airs  and  not  prepared  to  take  care  of  haphazard  re- 
turns that  drop  into  their  laps  from  time  to  time,  but 
who  desire  above  all  things  a  steady,  regular  and  de- 
pendable income.  Such  people  do  not  want  lean  years 
and  fat  years;  they  want  a  series  of  moderately  good 
years.  They  belong,  not  to  the  speculative,  but  to  the 
investment  class.  On  account  of  the  demand  that  such 
people  create  for  regular  dividend-paying  securities, 
the  market  prices  of  such  securities  are  far  higher  than 
they  would  otherwise  be.  For  example,  take  two 
stocks,  one  of  which  pays  over  a  series  of  five  years,  4 
per  cent,  7  per  cent,  6  per  cent,  3  per  cent  and  5  per 
cent,  averaging  5  per  cent  for  the  period,  and  compare 
it  with  another  stock  which  has  regularly  paid  5  per 
cent  each  year;  you  will  always  find  a  marked  difl'er- 


DISPOSITION  OF  GROSS  EARNINGS  309 

ence  in  market  price  in  favor  of  the  second  stock.  The 
principal  reason  for  this  difference  is  that  so  many 
people  prefer  a  regular  dividend  payer. 

It  is  for  the  best  interests  of  all  a  corporation's  stock- 
holders to  pay  regularly  a  steady  rate  of  dividend, 
inasmuch  as  the  market  price  is  thereby  enhanced.  The 
corporation  manager,  then,  is  confronted  with  the  prob- 
lem of  reconciling  this  demand  with  the  irregularity  of 
the  corporate  profits.  The  only  safe  method  of  accom- 
plishing this  result  is  to  pay  out  in  dividends  no  more 
than  the  minimum  earnings  of  the  corporation  in  its 
worst  years.  Thus  the  dividends  may  always  be  kept 
at  a  fixed  rate  and  whatever  is  earned  above  the  dividend 
requirements,  will  go  into  the  company's  surplus. 

172.  Prudence  in  paying  dividends, — This  may  seem 
an  unnecessarily  harsh  rule,  for  it  keeps  the  rate  of 
dividends  low  and  thereby  unnecessarily,  it  may  seem, 
cuts  down  the  stockholders'  income.  In  the  long  run, 
however,  it  works  no  injustice.  As  we  shall  see  in  suc- 
ceeding chapters,  whatever  surplus  is  saved  out  of  in- 
come, goes  to  increase  the  company's  earning  power  and 
Wventually  its  regular  dividend  rate. 
i  Looking  back  over  the  ground  covered  in  this 
:  chapter,  we  see  that  great  care,  prudence  and  foresight 
on  the  part  of  a  corporation  directorate  in  the  distribution 
of  gross  earnings  is  necessary  in  order  to  give  perma- 
nence and  long-continued  success  to  the  corporation. 
The  board  of  directors  must  see  to  it  that  the  gross  earn- 
ing of  each  year  are  not  overstated  and  that  operating 
expenses  are  not  understated.  In  connection  with  the 
latter  item  they  must  take  care  that  sufficient  reserve  has 
been  set  aside  to  provide  for  accrued  repairs  and  for 
depreciation.  They  must,  of  course,  meet  all  the  fixed 
charges  of  the  corporation  out  of  income  under  penalty 


310  CORPORATION  FINANCE 

of  seeing  the  company  forced  Into  bankruptcy.  They 
must  pay  cumulative  preferred  dividends  so  far  as 
practicable,  although  in  this  regard  some  discretion  is 
permitted  to  them.  Finally  they  must  resist  unwise 
pressure  from  stockholders  for  larger  dividends  than 
the  condition  of  the  company  in  the  long  run  will 
warrant.  If  they  do  not  resist  these  demands,  the  com- 
pany will  be  compelled  probably  sooner  or  later  to 
reduce  its  dividend  rate,  thus  removing  its  stocks  from 
the  class  of  desirable  investments  and  lowering  their 
market  prices.  The  ideal  corporation  director  will 
stand  like  Horatius  at  the  bridge,  defending  the  wealth 
and  profits  of  the  corporation  from  the  onslaughts  of 
hungry  stockholders  who  do  not  possess  either  foresight 
or  intimate  knowledge  of  the  business. 

A  corporation  which  has  such  a  directorate  is  peculi- 
arly fortunate,  and  whatever  its  line  of  business,  may 
reasonably  expect  to  attain  a  lasting  success.  A  cor- 
poration which  does  not  have  such  a  board  will  perhaps 
prosper  for  a  season  and  apparently  enrich  its  officers 
and  stockholders.  In  the  end,  however,  it  will  prove 
to  be  but  a  mushroom  growth.  All  the  while  its  vitality 
is  dwindling,  its  substance  is  being  eaten  out  and  sooner 
or  later,  to  the  surprise  of  unwary  investors,  it  suddenly 
crumbles  away. 


CHAPTER  XXII 

BETTERMENT  EXPENSES 

173.  Two  classes  of  betterments, — All  improvements 
and  all  expansions  of  property  may  be  grouped  under 
the  general  name  "betterments."  The  question  as  to 
whether  betterments  should  be  made  or  not  is  primarily 
something  for  the  operating  officials  of  the  company  to 
decide.  They  should  understand  thoroughly  the  condi- 
tion of  the  property,  the  cost  of  the  proposed  better- 
ments and  the  prospects  for  additional  business,  and 
from  the  study  of  these  factors  should  be  able  to  draw 
pretty  definite  conclusions  as  to  their  advisability. 

All  betterments  may  be  roughly  divided  into  two 
groups : 

(a)  Those  which  are  practically  certain  to  bring 
about  an  immediate  increase  in  revenue. 

(b)  Those  which  are  expected  to  prove  profitable  in 
the  long  run,  but  which  may  or  may  not  bring  immediate 
returns. 

As  an  example  of  the  first  class,  we  may  suppose  that 
a  manufacturing  company  is  about  to  put  in  a  new  and 
expensive  engine;  in  such  a  case  the  proper  officials 
should  be  able  to  calculate  in  advance  almost  exactly  the 
annual  saving  that  will  be  made  possible  by  this  partic- 
ular improvement. 

As  an  example  of  the  second  class,  we  may  suppose 
that  the  same  company  is  considering  the  advisability  of 
building  a  Young  Men's  Christian  Association  reading 
room  and  gymnasium  for  the  benefit  of  their  employes. 

311 


312  CORPORATION  FINANCE 

Their  motives,  we  may  presume,  are  not  in  the  least 
philanthropic;  they  expect  the  investment  to  yield  big 
returns  in  the  form  of  a  better  satisfied  and  more  intelli- 
gent force  of  workingmen.  The  extent  of  the  returns, 
however,  cannot  be  calculated  exactly  and  in  any  case 
will  not  be  immediate. 

The  dividing  line  between  the  two  classes  is  not  al- 
ways very  clear  and  there  may  often  be  more  difficulty 
than  in  the  two  examples  just  cited  in  assigning  a  pro- 
posed betterment  to  its  proper  class.  The  classification, 
however,  consciously  or  unconsciously,  is  almost  always 
made  by  intelligent  corporate  officials  and  directors. 

174.  Sources  of  funds  for  betterments, — Once  a 
betterment  expense  has  been  agreed  to,  the  next  ques- 
tion is  how  to  raise  the  necessary  funds.  This  is  a 
purely  financial  question,  which  deserves  even  fuller 
consideration  than  is  possible  within  our  space  limits. 
At  bottom  the  problem  of  raising  capital  funds  for 
betterments  is  of  the  same  general  character  as  the  prob- 
lem of  raising  the  initial  capital  funds  when  a  corpora- 
tion starts  business.  There  are,  however,  as  we  shall 
see,  some  important  variations  in  the  problem. 

The  sources  of  capital  funds,  whether  at  the  begin- 
ning or  during  the  corporation's  existence,  are  the  same 
as  have  already  been  given,  namely: 

(a)  The  active  managers  of  the  corporation. 

(b)  Surplus  earnings. 

(c)  Trade  creditors. 

(d)  Banks. 

(e)  The  investing  public. 

(f )  The  speculative  public. 

For  our  present  purpose  we  may  eliminate  sources 
(a),  (c)  and  (d).  There  is  nothing  to  be  said  with 
regard  to  them  that  has  not  already  been  said  in  Chapter 


BETTERMENT  EXPENSES  313 

VII.  There  remain:  source  (b),  from  which  the  funds 
may  be  obtained  by  one  of  two  methods,  either  direct 
appropriations  from  surplus,  or  abnormally  high  oper- 
ating expenditures;  source  (e),  which  may  be  reached 
either  by  the  issue  of  medium-term  notes  or  by  the  issue 
of  bonds;  and  source  (f )  from  which  funds  may  be  ob- 
tained by  the  sale  of  new  stock. 

175.  Appropriations  from  earnings. — The  safest  and 
surest  known  method  for  providing  for  betterments  and 
building  up  any  concern  is  by  making  appropriations 
out  of  earnings.  Expansion  that  is  financed  in  this 
manner  will  be  very  slow,  to  be  sure,  unless  the  profits 
of  the  concern  are  inordinately  large.  This  very  slow- 
ness, however,  is  in  some  respects  an  advantage.  It 
necessitates  a  gradual  growth,  a  kind  of  evolution  of 
the  business,  and  thus  automatically  provides  against 
waste  and  recklessness.  It  is  practically  certain  that 
any  concern  which  is  built  up  altogether  or  in  large 
part  by  means  of  appropriations  from  each  year's  sur- 
plus will  be  conducting  its  business  along  conservative 
lines.  That  it  is  not  impossible  by  this  method  to  con- 
struct in  time  an  immense  and  profitable  concern  is 
proved  by  the  history  of  two  of  our  great  industrials,  the 
Carnegie  Steel  Company  and  the  Baldwin  Locomotive 
Works.  The  Carnegie  Company  had  its  inception  in 
1871  in  an  insignificant  steel-making  plant  which  was 
bought  with  the  few  thousand  dollars  that  Andrew 
Carnegie  and  his  associates  were  able  with  great 
difficulty  at  that  time  to  command.  It  has  since 
expanded  until  it  is  to-day  worth,  as  a  going  concern, 
perhaps  a  half -billion  dollars ;  and  all  that  expansion  has 
been  the  result  of  profits  slowly  turned  back  into  the 
business.  In  this  respect  the  history  of  the  Baldwin 
Locomotive  Works  is  closely  similar. 


314  CORPORATION  FINANCE 

176.  Objections  to  this  method, — Yet  in  spite  of 
these  great  successes  we  must  not  overlook  the  two 
obvious  disadvantages  of  this  method  of  obtaining  funds 
for  betterments.  The  first  and  most  vital  objection  is 
that  the  slowness  of  the  process  may  occasion  the  loss 
of  valuable  opportunities.  While  an  old,  conservative 
company  is  thus  gradually  acquiring  the  funds  neces- 
sary for  the  expansion  of  its  business,  it  may  well  be 
that  a  somewhat  more  daring  concern  may  borrow  the 
funds  necessary  for  expansion  and  thus  capture  the  op- 
portunity that  was  at  first  open  to  both  of  them. 
Conservatism  undoubtedly  is  a  business  virtue;  yet  for 
the  best  results  it  needs  to  be  mixed  with  a  strong  dash 
of  speculative  fervor.  The  second  objection  is  that  the 
ordinary  stockholder  in  any  concern  desires  to  enjoy 
the  profits  of  a  business  as  they  are  earned  and  objects 
strongly  to  having  those  profits  diverted  to  betterment 
expenses.  It  is  true  that  an  increase  in  the  corpora- 
tion's assets  is  an  increase  in  his  assets,  for  he  is  part 
owner  of  the  corporation.  It  is  true,  also,  that  an  in- 
crease in  assets  will  be  to  some  extent  reflected  in  a  rise 
in  the  market  value  of  his  stock,  so  that  he  may  sell  out 
if  he  chooses  and  put  his  money  into  a  more  liberal  cor- 
poration. This  last,  however,  is  not  a  wholly  satisfac- 
tory argument  to  the  stockholder,  for  market  values 
are  based  more  largely  on  earnings  and  dividends  than 
they  are  on  underlying  assets.  This  is  a  truth  that  will 
be  found  fully  illustrated  in  the  volume  on  Investment 
AND  Speculation.  Thus  the  body  of  stockholders  is 
apt  to  oppose  strenuously  a  reduction  in  their  dividends 
in  order  to  provide  for  betterments.  It  seems  to  them  as 
if  they  were  being  compelled  to  make  a  sacrifice  for  the 
benefit  of  future  stockholders. 

177.  The    attitude    of    stockholders, — An    example 


BETTERMENT  EXPENSES  315 

that  has  been  conspicuous  lately  is  the  long-drawn-out 
struggle  on  the  part  of  minority  stockholders  in  the 
Wells-Fargo  Express  Company  tor  larger  dividends. 
This  company  is  controlled  by  the  Harriman  party,  and 
Mr.  E.  H.  Harriman,  following  his  usual  policy,  has 
been  perhaps  too  much  inclined  to  sacrifice  dividends  to 
financial  strength.  The  minority  stockholders  contend 
that  the  Wells-Fargo  Company  has  been  pihng  up  an 
enormous  surplus  which  is  not  needed  or  used  in  the 
business,  but  is  invested  in  the  securities  of  other  com- 
panies. The  majority  stockholders — that  is  the  Harri- 
man party — rejoin  that  the  security  holdings  of  the 
Wells-Fargo  Company  are  for  the  sake  of  control  and 
for  the  prevention  of  ruinous  competition;  in  other 
words,  that  earnings  have  been  consistently  devoted  to 
betterments.  The  undeniable  facts  are  that  the  com- 
pany is  highly  prosperous,  is  paying  relatively  small 
dividends  and  is  more  or  less  harassed  by  a  considerable 
body  of  dissatisfied  stockholders. 

The  objections  by  the  stockholders  in  such  cases  may 
be  induced  by  any  or  all  of  three  motives : 

(1)  They  may  simply  be  anxious  for  present  divi- 
dends, even  though  they  be  paid  at  the  risk  of  reducing 
the  corporation's  future  earnings  and  prosperity. 
Human  nature  is  so  constituted  that  to  almost  all  of  us 
$1  this  year  looks  better  than  $2  five  years  from  now. 

(2)  Some  of  the  stockholders  may  have  speculative 
tendencies  which  lead  them  to  desire  a  good  market 
price  and  a  quick  sale  for  their  stock — perhaps  with  the 
idea  that  after  a  while  the  dividends  will  be  cut  and  they 
will  be  able  to  repurchase  stock  at  much  lower  prices. 
This  motive  will  always  be  strong  when  many  of  the 
stockholders  belong  to  the  speculating,  rather  than  to 
the  investing  class.     Here  is  one  of  the  best  reasons 


316  CORPORATION  FINANCE 

why  a  conservative  corporation  manager  will  desire  to 
put  his  stocks  on  an  investment  basis  from  the  very 
beginning,  if  possible. 

(3)  The  stockholders  in  a  corporation  which  has  a 
large  funded  debt  may  reason  that  whatever  sums  are 
diverted  from  dividends  to  betterments  go  to  increase 
the  security  and  the  value  of  the  corporation's  bonds 
rather  than  of  its  stock.  We  shall  have  occasion  to 
deal  with  this  motive  and  its  results  when  we  take  up  in 
Chapter  XXVII  the  methods  of  manipulation  for  the 
benefit  of  the  body  of  stockholders.  It  is  enough  to  say 
here  that  this  motive,  although  narrowly  selfish,  is  still 
entirely  legitimate  and  often  has  great  weight. 

Wherever  these  motives  are  at  work — and  some  or  all 
of  them  are  likely  to  be  strong  in  almost  any  body  of 
stockholders — objections  to  heavy  betterment  expendi- 
tures out  of  earnings  will  be  in  evidence. 

In  the  Wells-Fargo  case  the  protesting  stockholders, 
however  disagreeable  they  may  make  themselves,  do  not 
have  much  influence  with  the  management,  because  they 
are  distinctly  in  the  minority.  It  often  happens,  how- 
ever, that  the  active  managers  of  a  corporation  are  more 
prudent  or  more  farsighted  than  the  majority  of  their 
stockholders  and  for  the  good  of  the  corporation  desire 
to  pursue  a  policy  of  small  dividends  and  large  better- 
ment expenses  which  would  not  be  supported  if  it  were 
clearly  presented  to  the  stockholders.  In  order  to  attain 
their  object  the  corporation  officers  must  keep  the  stock- 
holders more  or  less  in  the  dark ;  and  this  they  do  by  the 
very  simple  process  of  charging  their  expenditures  for 
betterments  under  the  head  of  operating  expenses. 

178.  The  case  of  the  Lehigh  Valley  Railroad, — The 
history  of  the  Lehigh  Valley  Railroad  so  well  illustrates 
the  workings  and  the  results  of  this  species  of  well-inten- 


BETTERMENT  EXPENSES  317 

tioned  deceit  that  it  is  worth  a  rapid  review.  In  the 
year  1897  new  interests,  which  were  represented  in  the 
active  management  by  President  Walters,  came  into 
control  of  this  company.  The  five  years  following, 
1898  to  1902  inclusive,  were  a  period  of  remarkable 
development  and  prosperity  for  almost  all  the  railroads 
and  industrial  corporations  of  the  United  States,  and 
the  Lehigh  Valley  was  no  exception.  Gross  earnings 
from  operation  increased  25  per  cent;  the  revenue 
tonnage  increased  150  per  cent;  at  the  same  time  the 
average  freight  rate  per  ton  per  mile  showed  a  slight 
gain.  On  the  other  hand,  the  outlay  per  train  mile 
for  moving  this  tonnage  decreased.  Thus  earnings 
were  apparently  going  up  while  running  expenses  rela- 
tively were  decreasing,  and  a  largely  increased  net 
income  would  naturally  have  been  expected  to  follow. 
The  facts  were,  however,  that  the  gross  income  (not 
gross  earnings)  decreased  from  $6,800,000  in  1898  to 
$4,800,000  in  1901  and  $4,650,000  in  1902,  when  the 
anthracite  coal  strike  was  in  progress. 

An  inquiring  stockholder,  who  might  have  chanced 
to  consider  with  care  these  strange  and  anomalous 
figures,  would  perhaps  have  turned  to  the  balance  sheet 
of  the  company  in  the  expectation  of  finding  therein 
revealed  some  noteworthy  addition  to  assets  purchased 
out  of  earnings.  But  our  inquiring  friend  would  have 
been  disappointed.  He  would  have  found  the  compara- 
tive figures  of  the  important  assets  of  the  road  as 
follows: 

'ASSETS 

1898  1902 

Cost  of  Road $18,639,291.95  $18,639,291.95 

Cost  of  Equipment ,.      19,018,419.98  19,018,419.98 

Securities  owned  . .  . .. 32,949,322.14  39,300,209.80 


318  CORPORATION  FINANCE 

The  only  change  here  is  an  increase  in  the  securities 
owned,  which  is  not  sufficient  in  amount  to  account  for 
all  that  apparently  should  have  been  saved  out  of  earn- 
ings. The  book  values  of  road  and  equipment,  it  will 
be  noticed,  have  not  been  changed. 

The  true  explanation  could  have  been  found  only  by 
analysis  of  the  operating  expenses  of  the  railroad.  In 
the  first  place,  the  proportion  of  total  operating  ex- 
penses to  gross  earnings  from  operations — or  operating 
ratio,  as  it  is  called — had  risen  from  70  per  cent  in  1898 
to  81  per  cent  in  1902.  As  a  normal  railroad  operating 
ratio  would  be  60  to  65  per  cent,  it  is  evident  that  this 
extraordinarily  high  ratio  of  the  Lehigh  Valley  in  1902 
indicated  one  of  two  things:  either  bad  management  or 
inflated  operating  expenses.  We  may  get  some  light 
as  to  which  was  responsible  in  the  present  case  by  a  slight 
further  analysis  of  operating  expenses.  In  1895 
22  5-10  per  cent  of  the  total  operating  expense  went  to 
maintenance  of  way;  in  1902  over  40  per  cent.  In  1895 
the  average  train-load  was  384  tons;  in  1902,  467  tons. 
Evidently  large  sums  had  been  devoted  during  the 
interim  to  betterments  which  greatly  increased  the 
economy  and  efficiency  of  the  road's  management.  We 
are  now  informed  that  during  the  ^ve  years,  1898  to 
1902,  all  new  equipment,  all  side-tracking  and  other 
expansions  of  track,  all  contruction  of  bridges  and 
buildings,  all  reballasting  of  track  and  similar  items 
had  been  charged  to  operating  expenses.  Professor 
Edward  Sherwood  Meade,  to  whose  searching  analysis 
we  are  indebted  for  much  of  the  information  here 
presented,  estimates  that  in  these  five  years  the  Lehigh 
Valley  under  Mr.  Walters'  management,  spent  almost 
$13,000,000  on  betterment  expenses  which  ordinarily 
would  have  been  provided  for  by  new  issues  of  stock  or 


BETTERMENT  EXPENSES 


319 


bonds;  in  other  words,  the  $13,000,000  under  a  different 
management  would  have  been  distributed  to  stock- 
holders. 

In  1902  a  new  management  came  into  power,  and  the 
report  for  the  fiscal  year  1903  shows  some  radical 
changes  in  accounting  methods.  Net  income,  for  in- 
stance, which  had  been  $4,650,000  the  preceding  year, 
suddenly  jumped  to  $8,300,000.  The  new  manage- 
ment, after  appropriating  $1,250,000  for  betterments 
and  after  paying  all  fixed  charges,  was  still  able  to  show 
over  $2,000,000  available  for  dividends ;  this,  in  the  face 
of  a  deficit  after  allowing  for  fixed  charges  the  pre- 
ceding year  of  over  $1,200,000.  In  1904  the  stock  was 
given  a  dividend  of  1  per  cent.  In  1905  it  was  put  on 
a  4  per  cent  basis.  Between  1901  and  1908  the  gross 
earnings  of  the  Lehigh  Valley  have  increased  about  33 
per  cent.  Its  net  earnings  have  considerably  more  than 
doubled,  and  its  fixed  charges  have  been  increased 
scarcely  at  all.  The  figures  below  tell  the  whole  story 
of  this  remarkable  growth  more  plainly  than  it  could  be 
put  in  words. 


i 

1908 

1901 

Increase 

Miles  operated  .... 

1,447 

1,382 

65 

Gross   earnings    .  .  . 

.   $35,510,154 

$26,688,533 

$8,826,621 

Gross,  per  mile   .  .  . 

24,500 

19,300 

5,200 

Net  earnings    

12,183,582 

5,765,113 

6,418,469 

Net,  per  mile 

8,420 

4,170 

4,250 

Chgs,  less  other  inc. 

4,813,008 

4,364,800 

448,208 

Charges,  per  mile   . 

3,320 

3,150 

170 

Surplus 

7,370,574 

1,400,313 
1,013 

5,970,261 
4,087 

Surplus,  per  mile    .  . 

5,100 

Now  what  is  the  meaning  of  these  facts  and  figures? 
In  the  first  place,  it  is  plain  that  the  road  was  in  poor 


320  CORPORATION  FINANCE 

condition  prior  to  Mr.  Walters'  administration  and  that 
he  left  it  in  such  excellent  condition  that  its  net  earnings 
have  since  shown  a  phenomenal  increase.  There  can 
be  no  question  but  that  the  millions  which  Mr.  Walters 
poured  into  the  property  were  wisely  spent  and  have 
since  been  efficiently  administered.  To  an  investor  or 
corporation  manager  this  review  should  be  an  inspiring 
story  of  honest  profits  ably  secured. 

Nevertheless,  it  must  be  admitted  that  Mr.  Walters' 
policy,  so  far  as  the  stockholders  were  concerned,  was 
one  of  evasion  and  deceit.  True  it  is  that  whatever 
he  did  was  intended  for  their  own  best  interests;  yet  it 
is  also  true  that  they  would  not  always  have  approved 
of  his  actions  if  they  had  known  exactly  what  was  going 
on.  We  do  not  need  to  enter  into  the  ethics  of  the  case. 
It  is  plain,  however,  that  the  stockholders,  from  any  or 
all  of  the  motives  we  have  previously  mentioned,  might 
with  justice  have  objected  to  Mr.  Walters'  course.  As 
a  matter  of  fact,  they  did  finally  become  alive  to  the 
situation  and  helped  in  bringing  a  new  management 
into  power. 

179.  Policy  of  the  Union  Bag  and  Paper  Company, 
— Another  illustration  of  large  operating  expenses 
being  used  to  beguile  stockholders  into  putting  a  large 
portion  of  earnings  into  betterments  is  to  be  found  in 
the  recent  history  of  one  of  the  smaller  trusts,  the  Union 
Bag  and  Paper  Company.  In  a  review  of  this  com- 
pany's condition,  recently  issued,  we  find  the  following 
remarks : 

Benefit  is  now  being  derived  from  the  liberality  with  which  out- 
lays for  repair  work,  maintenance  and  improvements  have  been 
made.  Since  the  formation  of  the  company  nine  years  ago, 
about  $3,000,000  have  been  expended  in  construction,  purchase 
of  woodlands,  etc.,  in  addition  to  requirements  for  ordinary  re- 


BETTERMENT  EXPENSES  321 

pairs  and  maintenance,  which  have  been  charged  directly  to 
operating  expenses,  and  also  in  addition  to  the  amounts  ex- 
pended in  1906  for  the  property  of  the  Gres  Falls  Company 
and  that  of  the  Allen  Bros.  Company.  AU  told  over  $6,000,000 
have  been  expended,  since  the  company's  incorporation,  for  ad- 
ditional property  and  new  construction,  and  the  company  has 
increased  its  capital  obligations  only  to  the  extent  of  $2,439,- 
000.  While  the  company's  physical  and  producing  capacity 
has  been  undergoing  improvement,  its  financial  position  has  also 
been  bettered,  net  working  capital  having  been  increased  in  the 
past  four  years  by  approximately  $1,058,000  or  about  100 
per  cent. 

180.  Borrowing  funds  for  betterments. — The  third 
means  of  raising  funds  for  betterments  is  through  issues 
of  medium-termnotesj^  It  is  not  necessary  to  consider 
this  method  with  great  care,  inasmuch  as  it  has  already 
been  discussed  in  Chapter  VIII.  The  examples  given 
there  was  sufficient  to  show  the  dangers  of  this  method. 
Obviously  it  cannot  properly  be  utilized  except  to  pro- 
vide for  betterments  which  are  practically  certain  to 
yield  large  and  immediate_pxQfi±&;  otherwise  the  corpo- 
ration will  be  incurring  obligations  that  must  be  met 
out  of  income  and  that  will  perhaps  become  exceedingly 
dangerous. 

A  much  better  method,  generally  speaking,  of  secur- 
ing the  funds  for  permanent  betterments  is  by  means  of 
long-term  bonds.  As  has  been  previously  explained, 
large  well-established  corporations  do  not  usually  expect 
to  gaxj?ff  these  bonds  when  they  fall  due,  but  plan  to 
refund  theni^bj^jaew  issues^  In  other  words,  what  they 
actually  do  is  to  incur  a  permanent  fixed  charge.  Now 
i^  a  betterment  is  of  such  a  character  that  it  is  practically 
certam  to  producejprofit§  year  after  year  larger  than 
the  fixed  charges  assumed  in  order  to  make  the  better- 


S22  CORPORATION  FINANCE 

ment,  it  is  no  doubt  good  policy  to  raise  the  necessary; 
funds  by  the  issue  of  long-time  obligations. 

181.  Policy  of  the  Pennsylvania  Railroad. — The  set- 
tled policy  of  the  Pennsylvania  Railroad  is  the  best 
known  and  most  consistent  illustration  of  the  working 
of  this  principle.  This  company,  it  is  understood, 
separates  all  its  betterment  expenses  into  the  two  classes 

/  previously  named :  First,  those  which  will  in  all  human 
probability  result  in  a  permanent  saving  or  profit  more 
than  equal  to  interest  on  the  funds  thus  invested ;  second, 

V  those  which  will  probably  prove  profitable,  but  which 
may  or  may  not  yield  profits  in  the  immediate  future. 
,To  the  first  group  the  Pennsylvania  management 
assigns  such  betterments  as  shortening  and  straighten- 
ing a  line,  cutting  down  grades,  providing  new  equip- 
ment where  an  increase  in  trafiic  is  certain,  and  so  on; 
to  the  second  class  they  assign  such  betterments  as  a 
large  part  of  the  tunnel  construction  in  and  around  New 
sYork  City,  providing  new  equipment  for  a  hoped-for  in- 
crease in  traffic,  operating  passenger  stations,  and  so  on. 
The  Pennsylvania  Railroad's  custom  is  to  pay  for  all 
betterments  of  the  first  class  by^  bond  issues  and  for 
all  betterments  of  the  second  class  by  appropriations 
fromsurpjus. .  Thus  the  stockholders  secure  at  the  same 
time  the  maximum  of  returns  and  the  maximum  of! 
safety.  It  is  the  ideal  policy  as  regards  betterments 
and  will  no  doubt  be  more  generally  adopted  in  the 
future  by  railroad  and  industrial  corporations. 

To  illustrate  its  workings  in  the  concrete  case  of  the 
tunnel  into  New  York  City  and  accompanying  improve- 
ments, the  following  figures  are  presented.  Up  to  the 
end  of  1908  the  total  cost  of  the  tunnel  extension,  as 
shown  by  the  annual  reports,  was  $77,528,664,  of  which 
only  60  per  cent  has  been  capitalized.     The  total  cost 


BETTERMENT  EXPENSES  323 

is  covered  by  the  following  charges  on  the  books  and 
appropriations  of  surplus  profits: 

Cost  on  Books,  December  31,  1908 .:.  $46,528,664 

Charged  to  surplus  income  of  1908     ,  1,000,000 

Charged  to  profit  and  loss  account  in  190T    .  .  7,000,000 

Charged  to  profit  and  loss  account  in  1906     .  .  13,000,000 

Charged  to  profit  and  loss  account  in  1905     .  .  5,000,000 

Charged  to  profit  and  loss  account  in  1903     .  .  5,000,000 


Total  cost  of  tunnel  extension  of  end  of  1908  .  .    $77,528,664 

The  cost  on  the  books  given  above  is  the  figure  at 
which  the  Pennsylvania  Railroad  carries  the  work 
already  accomplished  as  an  asset.  But  in  1908  the 
Pennsylvania  Railroad  proper  required  the  lines  west 
of  Pittsburg  to  assume  a  part  of  the  burden  and  accord- 
ingly the  Pennsylvania  Company  turned  over  $10,000,- 
000  in  securities,  deducting  the  value  thereof  from 
its  profit  and  loss  surplus.  Assuming  that  the  income 
derived  from  these  securities  will  defray  the  interest 
charges  on  $10,000,000  of  the  capital  invested  in  the 
tunnel,  the  Pennsylvania  Railroad  will  have  to  look  to 
the  operation  of  that  property  to  yield  fixed  charges 
upon  capital  borrowings  to  date  of  only  about 
$36,500,000. 

182.  General  conclusions  as  to  the  financing  of  better- 
ments. — The  only  remaining  method  to  consider  of  se- 
curing funds  for  betterments  is  by  means  of  stock  issues. 
The  comparative  meritsLof  increasing  capitalization  by^^ 
means  of  gtock^^  as^ompared_with  bond,  issues  are  too 
obvious  to  need  much  discussion.  A  bond  issue  is  a 
cheaper  means  of  getting  the  necessary  funds,  for  bonds 
can  always  be  sold  to  better  advantage  than  stock  which 
yields  the  same  return;  on  the  other  hand,  bond  issues 


SU  CORPORATION  FINANCE 

are  objectionable  insofar  as  they  tend  to  increase  the 
fixedjcharges  and  thereby  imperil  the  safety  of  the  com- 
pany. New^tock  issues  are  safe  enough,  but  of  course 
tend  to  reduce  the  rate  of  distribution  on  the  stock  al- 
ready outstanding.  We  may,  perhaps,  lay  down  this 
r<A^  'i^^  general  rule,  that  betterments  of  the  second  class — fol- 
lowing the  classification  we  have  given — ought  to  be 
financed  either  out  of  surplus  or  by  means  o£  new  stock 
issues ;  betterments  of  the  first  class  ought  to  be  financed 
by Jiqndjssues,  or  in  rare  cases  by  issues  of  mediumjjberm 
notes. 

In  what  is  said  with  regard  to  the  financing  of  better- 
ments, as  in  all  other  general  questions  of  corporation 
policy,  we  must  be  content  with  broad  conclusions. 
Corporation  managers  who  differ  from  the  general 
principles  here  laid  down  are  not  necessarily  to  be  con- 
demned offhand.  They  may  have  good  reasons  which 
do  not  appear  on  the  surface.  Every  business  man 
must  base  his  actions,  not  so  much  on  general  principles, 
as  on  the  important  concrete  factors  that  confront  him. 
At  the  same  time  it  is  also  true  that  a  clear  understand- 
ing of  these  principles  and  of  the  practice  of  large  cor- 
porations will  aid  the  corporation  manager  in  handling 
more  intelligently  and  more  successfully  whatever 
peculiar  and  difficult  problems  arise  before  him. 


CHAPTER  XXIII 

CREATION  AND  USE  OF  A  SURPLUS 

183.  Definition. — One  of  the  most  talked  about  topics 
in  the  field  of  Corporation  Finance  is  the  "surplus," 
its  formation  and  its  management.  Yet  in  spite  of  all 
the  discussion,  there  is  still  a  great  deal  of  confusion  as 
to  what  a  surplus  is  and  what  it  is  good  for  even  in  the 
minds  of  lawyers  and  men  familiar  with  financial  af- 
fairs. The  main  principles  that  govern  the  manage- 
ment of  surplus  are  not  different  from  those  which 
should  control  the  management  of  other  capital  funds, 
and  are  simple  enough  to  seem  obvious  when  they  are 
once  clearly  stated.  That  they  are  not  always  clearly 
comprehended,  however,  is  proved  by  the  loose  writing 
and  thinking  with  regard  to  the  subject  that  is  so  often 
manifest. 

A  brief  satisfactory  definition  of  surplus  is  that  it 
is  the  difference  between  the  assets  and  the  obligations 
of  a  corporation,  including  under  "obligations"  all  the 
outstanding  stock  of  the  corporation,  as  well  as  its  re- 
serves and  debts.  Suppose,  for  instance,  that  we  have 
a  corporation  with  assets  of  all  kinds,  having  a  total 
book  valuation  of  $1,000,000,  and  having  on  the  other 
side  of  the  account  debts  represented  by  accounts  pay- 
able, bank  loans,  notes  and  bonds  of  $500,000,  deprecia- 
tion and  other  reserves  of  $50,000  and  outstanding  cap- 
ital stock  amounting  to  $250,000;  it  is  evident  that  the 
corporation  must  have  secured  $200,000  of  its  assets 
from  some  other  source  within  the  business;  and  that 

325 


326  CORPORATION  FINANCE 

source  we  call  surplus.  The  surplus  account,  as  is  ex- 
plained in  the  volume  on  Theory  and  Practice  of  Ac- 
counting, appears  on  the  liability  side  of  the  balance 
sheet,  because  it  is  an  amount  for  which  the  corporation 
must  render  an  account. 

184.  Four  sources  of  surplus, — In  our  discussion  of 
the  corporation's  surplus  we  will  consider : 

(a)  How  it  is  obtained. 

(b)  What  is  done  with  it. 

^   (c)   Its  uses  and  management. 

One  possible,  though  very  unusual,  means  by  which  a 
/  corporation  obtains  a  surplus  is  by  inheritance.  Take, 
for  instance,  a  corporation  which  is  a  consolidation  of 
two  companies,  each  having  a  surplus  of  its  own.  The 
consolidation  may  conceivably  simply  guarantee  the 
bonds  and  other  outstanding  debts  of  the  subsidiary 
companies,  may  issue  dollar  for  dollar  in  stock  for  the 
stock  of  the  subsidiary  companies  and  may  transfer  the 
former  surpluses  bodily  to  its  own  accounts.  As  we 
have  seen  in  our  study  of  the  formation  of  consolida- 
tions, however  (Chapter  XIV),  the  new  corporation 
will  usually  issue  securities  far  in  excess  of  the  market 
value  of  the  assets  of  the  old  companies.  The  con- 
solidation, therefore,  will  not  only  not  start  out  with  a 
surplus  usually,  but  will  be  compelled  greatly  to  over- 
value its  assets  in  order  to  make  a  balance  sheet  possible. 
We  may  dismiss  this  first  possible  source  of  surplus, 
then,  with  the  statement  that  it  is  too  uncommon  to  be 
worth  much  discussion. 

The  second  source  of  surplus,  which  also  is  rather 

unusual,  is  the  selling  of  the  corporatejstock^Qr  bonds 

above  par.     Evidently  the  corporation  in  such  a  case 

^ceives  a  surn  of  money  greater  in  amount  than  the 

obligations  which  it  incurs.     Now  this  extra  sum  may 


CREATION  AND  USE  OF  SURPLUS     327 

be  handled  bj:  an  accountant  in  three  or  four  different 
ways.  One  way  is  to  include  it  in  the  corporation's  sur- 
plus account.  The  propriety  of  this  method  may  be 
disputed,  but  this  is  an  accounting  rather  than  a  finan- 
cial question. 

-7  A  surplus  may  originate,  in  the  third  place,  in  whole 
or  in.  part  from  {he^ale  of  a  corporation's  fixed  or  semi- 
Bxed  assets.  Thus  if  a  manufacturing  company  owns 
a  plant  which  has  become  obsolete  and  worthless  for 
manufacturing  purposes,  and  the  value  of  which  has 
been  fully  covered  by  a  depreciation  reserve — ^in  other 
words,  written  off  the  books — and  afterwards  sells  this 
plant,  the  sum  resulting  would  go  into  the  surplus  ac- 
count. Of  course,  the  reader  will  understand  that  if  the 
value  of  the  plant  in  such  a  case  had  not  been  written  off 
the  books,  but  was  still  included  in  the  corporation's  bal- 
ance sheet,  the  only  effect  of  its  sale  would  be  a  transfer 
of  the  amount  received  from  the  property  account  to 
cash  or  notes  receivable  or  whatever  was  taken  in  pay- 
ment for  the  plant. 

/  A  similar  source  of  surplus  is  a  revaluation  of  the 
fixed  assets  of  a  corporation  when  the  revaluation  shows' 
an  increase  in  their  value.  ^  This  increase  would  nat- 
urally be  represented  on  the  liability  side  of  the  balance 
sheet  by  a  corresponding  gain  in  the  surplus.  Gen- 
erally speaking — and  it  must  be  remembered  that  there 
are  some  exceptions  to  this  rule — an  upward  revaluation 
of  assets  is  not  in  accordance  with  correct  accounting 
or  financial  principles.  Therefore,  this  fourth  source 
of  surplus  is  not  commonly  found. 

185.  The  fifth  source — saving. — This  Brings  us  to 

the  fifth  and  most  common  source  of  surplus,  namely, 

^  saving^from  income.     The  uses  to  which  income  should 

be  put  liave  been  discussed  at  some  length  in  Chapter 


S28  CORPORATION  FINANCE 

XXI ;  and  the  final  uses,  after  the  fixed  charges  and  re- 
serves had  been  provided  for,  were  found  to  be  divi- 
dends and  surplus.  It  will  do  no  harm  to  reiterate  the 
important  principle  there  laid  down  that  the  dividends 
of  practically  every  corporation  should  be  maintained 
at  a  fixed  rate  and  should  move  only  to  increase.  Fluc- 
tuating dividends  destroy  the  confidence  of  the  invest- 
ing public  and  greatly  reduce  the  credit  of  the  corpora- 
tion below  what  it  might  possess.  The  proper  policy, 
with  few  exceptions,  is  jto  ascertain  the  minimum_-net 
earnings  of  a  company  in  the  years  of  greatest  deprecia- 
tion and  rigidly  hold  the  dividends  at  or  below  that 
minimum.  The  rest  of  jhe  net  earnings  will  be  trans- 
weired  to  the  company's  surplus  account.     _ 

That  this  method  of  forming  a  surplus  may  build  it 
up  with  great  rapidity  is  shown  by  the  record  of  that 
great  industrial  concern,  the  Standard  Oil  Company. 
The  annual  net  profits,  the  sums  appropriated  to  surplus 
and  to  dividends,  and  the  totals  of  each  item  for  seven 
years  are  as  follows: 

Tear  Profits 

1908  $  80,000,000* 

1907  85,000,000* 

1906  83,122,251 

1905  57,459,356 

1904  61,670,110 

1903  81,336,994 

1902 64,613,363 

Total $513,202,074 

♦Approximated. 

It  is  evident  that  in  the  case  of  any  company  which 
follows  the  principle  just  laid  down,  the  proportion  of 
dividends  paid  will  vary  with  the  fluctuations  in  earn- 


Dividends 

Surplus 

after  divs. 

$  39,335,320 

$  40,664,680* 

39,335,320 

45,664,690* 

39,335,320 

43,786,931 

39,335,320 

18,124,036 

35,188,266 

26,481,844 

42,877,478 

38,459,516 

43,851,956 

26,761,307 

$279,258,980 

$233,943,094 

CREATION  AND  USE  OF  SURPLUS  329 

ings.  The  greater  those  fluctuations  the  more  rapid  will 
be  the  increase  in  surplus.  The  converse  proposition 
is  that  a  stable  rate  of  earnings  makes  unnecessary  the 
creation  of  a  big  surplus. 

186.  Policy  of  the  'trusts /"— Professor  Edward  S. 
Meade's  well-known  volume  on  "Trust  Finance"  gives 
the  result  of  a  careful  study  of  the  dividend  and  surplus 
policy  at  the  beginning  and  during  the  existence  of  all 
our  important  industrial  combinations  or  "trusts."  The 
prime  object  of  the  managers  of  almost  all  these  com- 
binations at  the  beginning,  Professor  Meade  points  out, 
was  to  pay  dividends  and  thereby  encourage  the  sale  of 
stock.  They  were  therefore  averse,  as  a  rule,  to^  ap- 
propriating any  considerable  amounts  to  the  surplus  ac- 
count. They  even,  in  some  cases,  incurred  a  deficit  in 
order  to  pay  dividends.  Professor  Meade  computes 
that  twenty-six  important  consolidations,  which  he  has 
studied  with  especial  care,  earned  in  the  four  years 
1898-1901,  $150,201,390.     He  says: 

This  amount,  although  large  in  the  aggregate,  represents 
but  little  more  than  3  per  cent  per  annum.  It  would  appear, 
as  already  stated,  that  every  consideration  of  prudence  would 
incline  the  directors  of  these  companies  to  reserve  practically 
all  their  profits  in  order  to  strengthen  the  financial  position  of 
their  companies.  So  far  from  following  the  path  of  prudence, 
however,  61.9  per  cent — almost  two-thirds  of  these  profits — 
were  paid  out  in  dividends,  leaving  38.1  per  cent  for  the  sur- 
plus reserve.  The  inadequacy  of  this  reserve  may  be  better 
understood  when  it  is  compared  with  the  outstanding  capital 
whose  permanent  value  it  was  intended  to  secure.  A  reserve  of 
only  4.2  per  cent  is  the  net  result  of  the  operations  of  three 
years. 

The  industrial  trusts, are  excellent  examples  of  cor- 
porations which  for  reasons  of  their  own  were  reluctant 


S30  CORPORATION  FINANCE 

to  keep  dividendsLdown  to  a  conservative  basis  and  to_ 
create  large  surpluses..  The  results  of  their  imprudence 
are  familiar  to  most  of  us — perhaps  entirely  too  familiar 
to  some.  The  common  and  preferred  stock  of  most  of 
these  companies  received  dividends  for  a  few  years,  but 
at  the  first  hint  of  trade  and  financial  depression,  earn- 
ings fell  off,  dividends  were  stopped  and  the  market 
prices  of  the  stocks  dropped  with  a  thud.  We  have  here 
presented  an  impressive  lesson  that  ought  to  be  mastered 
by  every  corporation  director  and  stockholder — Jhe  les- 
son that  in  times  of  plenty  provision  should  be  madC;.  ^ 
J;hrough  creation  of  an  adequate  surplus  account  out  of 
income,_f or  the  seasons  of  famine  that  are  sure  to  come. 

187.  How  should  surplus  be  invested, — ^We  have  next 
to  consider  what  form  the  surplus  of  a  corporation 
should  take,  or,  in  other  words,  how  it  should  be  invested. 
Its  possTDla^ forms  or  uses  are  as  numerous  as  the 
uses  to  whicMhe  original  capital  funds  of  a  corporation 
may  be  put,  a^^may  be  classified  under  the  following 
heads : 

(a)  Cash. 

(b)  Securities. 

(c)  Decrease  of'^rrent  liabilities. 

(d)  Sinking  fund. 

(e)  Increase  in  stoc\of  raw  materials  or  finished 
products  on  handi 

(f)  Betterments. 

(g)  Extensions  and  additions  to  fixed  assets. 
It  goes  without  saying  that  the  surplus  should  be  used 

to  strengthen  the  weak  spots,  whatever  they  may  be,  in 
the  corporation's  capital  equipment.  We  can  be  some- 
what more  specific,  however. 

188.  The  surplus  as  a  "rainy  day  fund/' — There  are 
[two  distinct  and  opposed  opinions  as  to  the  true  function 


'^u-rer 
stoclLc 


CREATION  AND  USE  OF  SURPLUS  331 

/  o?  a  surplus:  one,  that  it  should  be  merged  with  the  rest 
of  the  corporation's  capital  funds;  the  other,  that  it 
^should  be  set^ aside  as^an  insurance  against  future  losses. 
Let  us  first  consider  the  justification  and  the  results  of 
this  second  opinion.  Its  advocates  base  their  case  on  the 
assertion  that  the  original  investment  of  capital  funds, 
should  be  sufficient  to  carry  on  properly  all  the  business 
of  the  company;  if  these  funds  are  not  sufficient,  then 
they  should  be  increased  by  borrowing  or  by  bringing 
in  new  stockholders,  not  by  saving  out  of  profits.  The 
arguments  in  favor  of  providing  funds  for  betterment 
by  borrowing,  rather  than  by  saving,  have  already  been 
given  and  have  been  found  to  have  considerable  weight. 
The  advocates  of  this  opinion  are  convinced  of  the  ad- 
visability  of  maintaining  dividends  at  a  stable  rate^and 
conceive  it  to  be  the  true  function  of  a  surplus  account 
to  equalize  the  dividends  over  a  series  of  years.  In  other 
words,  the  surplus  account  should  be,  in  their  view,  as 
it  has  well  been  called,  simply  a  "rainy  day  fund,"  to 
be  drawn  upon  for  dividends  whenever  the  necessity 
arises. 
IK  It  follows,  if  this  opinion  is  correct,  that  the  surplus 
IHpught  to  take  the  form  of  cash  or  something  that  may 
^^^adily  be  turned  into  cash,  for  example,  securities. 
^HBtherwise,  it  will  not  be  readily  available  for  dividends 
in  periods  of  financial  stress  when  it  is  most  likely  to  be 
needed.  It  is  true,  to  be  sure,  that  a  surplus  may  be  in- 
vested in  permanent  assets  and  yet  be  treated  as  a  "rainy 
day  fund,"  for  these  assets  may  be  made  the  basis  of 
temporary  loans  to  the  corporation.  The  objection  here 
is  that  it  is  uncertain  whether  such  loans  can  be  obtained 
when  they  are  most  needed  and,  morecfver,  it  is  unsafe 
to  base  temporary  loans  on  a  corporation's  fixed  assets. 
On  the  whole,  then,  we  may  say,  that  if  the  surplus  ac- 


33^  CORPORATION  FINANCE 

count  is  to  be  regarded  simply  as  a  kind  of  reservoir  in 
which  future  dividends  for  lean  years  are  to  be  stored, 
that  reservoir  should  be  filled  with  cash  or  easily  market- 
able securities. 

The  chief  exponents  of  this  policy  are  the  great 
English  and  German  shipping  companies,  particularly 
the  Cunard  Company  and  the  Hamburg- American 
Line.  The  former  company  is  said  to  have  nearly  one- 
third  of  its  total  assets  invested  in  securities  which  have 
no  direct  connection  with  its  shipping  business.  If  the 
company  runs  into  a  period  of  intense  competition  dur- 
ing which  it  cannot  earn  dividends,  or  should  it  sustain 
severe  losses,  enough  securities  would  be  sold  to  maintain 
the  regular  dividend  rate.  There  are  obvious  advan- 
tages in  this  course;  on  the  other  hand,  there  are  disad- 
vantages equally  obvious  and  for  most  corporations  of 
controlling  importance. 
/  The  first  disadvantage  is  that  to  build  up  a  cash  sur- 
plus is  almost  a  waste  of  that  much  capital.  It  is  a 
waste  because  capital  in  that  formjearns  next  to  nothing. 
If  it  is  kept  as  a  permanent  cash  balance  jt  may,  to  be 
sure,  draw  interest  at  2  or  3  per  cent,  or  in  exceptional 
cases,  even  3%  per  cent;  but  this  is  a  totally  inadequate 
return  on  an  industrial  investment.  If  the  surplus  is 
in  the  form  of^narketable  securities  the  case  is  almost 
as  bad;  for  the  only  securities  that  are  marketable  in 
times  of  stringency  are  high-grade  bonds  which  do  not 
yield  above  taxes  more  than  3%  P^^  ^^^^  ^^  ^  P^^  ^^^^ 
^at  the  outside.  As  the  second  disadvantage,  it  must  be 
borne  in  mind  in  this  connection  that  funds  so  invested, 
though  safe  enough  from  the  corporation's  standpoint, 
do  not  give  the  corporation  stockholder  safety  sufficient 
to  compensate  for  the  small  yield.  What  is  meant  by 
this  statement  is  that  the  surplus,  however  invested,  is 


CREATION  AND  USE  OF  SURPLUS 

part  of  the  corporation's  capital  and  would  be  swallowed 
up  by  the  corporation's  creditors  in  case  of  bankruptcy. 
Thus  the  surplus  goes  to  protect Jhe  creditor  rather  than 
the  stockholder.  The  stockholder  would  be  much  better  _ 
off,  so  far  as  safety  is  concerned,  if_his  portion  of  the__ 
surplus  were  turned  over  to  hiin  individually  and  he 
would  himself  buy  good  securities  with  the  proceeds. 

189.  Putting  the  surplus  back  into  the  property. — 
Having  these  disadvantages  in  view,  corporation  man- 
agers jn^^his  country  have  almost  universally  put  the 
surplus,  of  their  corporations  ^ack  into  the  property. 
Sometimes  it  is  used  to  increase  the  cash  balance  where 
more  cash  is  really  needed  in  the  business,  or  to  buy 
securities  of  companies  which  it  is  desirable  to  control. 
In  both  these  cases,  however,  the  object  is  not  to  separate 
the  surplus  from  the  business,  as  it  is  when  the  rainy  day 
fund  is  formed,  but  to  make  it  productive  in  the  business. 
Sometimes  it  goes  into  betterments,  as  explained  in  the 
previous  chapter,  or  into  extensions  or  into  some  other  of 
the  seven  forms  mentioned  above.  Just  which  form 
shall  be  chosen  by  the  corporation  management  depends 
on  considerations  which  have  already  been  discussed  in 
the  chapter^iL_*^vestment^of  Cap  Funds."  As  a 
normal  return  on  capital  invested  in  commercial  enter- 
prises in  this  country  would  run  from  6  per  cent  on  up, 
it  is  evident  that  as  a  rule  the  investment  of  surplus  in 
the  business  in  which  it  was  produced  is  the  best  and  most 
profitable  policy. 

Perhaps  the  stockholder  may  object  at  this  point  that 
the  surplus  is  taken  from  the  profits  which  ought  to  be 
turned  over  to  him.  The  objection  is  superficial  and 
fails  to  take  into  account  the  various  methods  by  which 
a  surplus  may  be,  and  in  the  end,  must  be,  distributed 
to  the  corporation  stockholders.     Some  of  these  methods 


334.  CORPORATION  FINANCE 

are  not  well  understood;  indeed  it  is  doubtful  whether 
half  the  stockholders  in  business  corporations  realize  how 
or  when  their  surplus  is  distributed  to  them.  This  is  the 
interesting  topic  which  will  be  the  subject  of  our  next 
chapter. 


CHAPTER  XXIV 

^  DISTRIBUTION  OF  THE  SURPLUS 

190.  Effect  of  a  surplus  on  assets  and  dividends. — 
Ordinarily,  as  stated  in  the  preceding  chapter,  a  sur- 
plus is  formed  out  of  savings  from  income  and  is  in- 
vestedin  the_capital  assets  of  the  corporation.  Thus  it 
becomes  merged  at  once  with  the  capital  funds.  The 
average  stockholder  feels  that  it  is  lost  to  him.  He  sees, 
to  be  sure,  that  the  assets  of  the  corporation  are  increased 
by  the  formation  of  a  surplus,  and  he  will  admit  prob- 
ably, if  you  press  him,  that  theoretically  this  increase  in 
assets  is  a  good  thing  for  the  corporation  and  for  every 
stockholder  and  tends  to  increase  the  value  of  his  stock.^ 
The  admission,  however,  is  apt  to  be  grudgingly  made 
and  probably  does  not  disturb  the  stockholder's  convic- 
tion that  whatever  sums  are  devoted  to  surplus  are  taken 
out  of  the  pockets  of  the  owners  of  the  corporation.  He 
sees  how  these  .sums__are  taken  away  from  him,  but  does 
not  see  clearly  injwhat  form  they  come  back  to  him. 
The  object  of  this  chapter  is  to  explain  the  niethpds  by 
which  the  surplus  may  be  and  generally  is  returned. 

It  has  already  been  mentioned — and,  for  that  matter, 
is  self-evident — that  surplus  wisely  invested  in  capital 
assets  increases  the  earning  power  of  the  corporation  and 
therefore  its  ability  to  pay  large  dividends.  Moreover, 
the  surplus  when  properly  invested  so  as  to  extend  the 
sales  of  the  corporation  or  its  ownings  of  raw  materials, 
or  its  control  over  competitive  plants,  tends  strongly  to 
make  earnings  more  stable  and  therefore  to  make  prac- 

335 


336  CORPORATION  FINANCE 

ticable  a  distribution  in  dividends  of  a  larger  proportion 
of  earnings.  This  is  a  point  not  often  alluded  to  and 
worth  a  word  of  explanation.  It  is  evident  that  gen- 
erally speaking  the  larger  the  business  a  concern  does, 
the  more  stable  and  dependable  will  be  its  earnings — for 
slight  local  fluctuations  up  and  down  will  almost  always 
balance  each  other.  If  a  big  jobbing  corporation  loses 
trade  for  local  reasons  in  one  section  of  the  country,  it 
may  reasonably  hope  that  gains  in  other  sections  will  at 
least  counterbalance  the  loss.  It  is  also  true  that  con- 
trol, even  partial  control,  over  the  prices  of  raw  materi- 
jals  or  of  unfinished  products  tends  to  make  earnings 
more  stable.  It  may  well  happen  for  these  reasons  that 
a  relatively  small  surplus  will  have  a  more  than  propor- 
tionate influence  on  a  corporation  dividend  rate — not^so^ 

jnuch,  to  reiterate,  b^ecause.it^increases  earnings,  a^^e- 
cause  it  makes  them  more  uniform. 

Frequently — and  this  is  especially  true  of  a  close  cor- 
poration^—no  individual  stockholder^  wpuld  be  able  to 
save  and  invest  to  such  good  advantage  as  the  corpora- 
tionTcairdo  for  him.     Take  once  more  the  famous  ex- 

"ainple  of  the  Carnegie  Steel  Companx^  Does  anyone 
suppose  that  any  single  stockholder  in  that  company 
would  have  become  as  wealthy  if  the  earnings  had  reg- 
ularly been  paid  out  to  the  stockholders  in  dividends 
instead  of  being  put  back  year  after  year  into  the  prop- 
erty? The  stockholders  did  not  receive  very  large  div- 
idends for  many  years,  and  some  perhaps  were  inclined 
to  complain  that  they  were  not  getting  the  returns  on 
their  investment  that  were  justly  due  them.  In  this 
case  the  stockholders  were  never  given  any  considerable 
proportion  of  earnings,  nor  was  the  vast  surplus  of  the 
company  distributed,  except  to  a  limited  extent,  until 
the  sale  of  the  Carnegie  Steel  Company  in  1901  to  the 


DISTRIBUTION  OF  THE  SURPLUS  337 

United  States  Steel  Corporation.  Then  the  extraor- 
dinary strength  and  riches  of  the  company  were  suddenly 
revealed.  Almost  a  half -billion  dollars  in  cash  or  salable 
securities  were  showered  upon  the  fortunate  stockholders 
of  the  company.  Pittsburg,  like  a  night-blooming 
cereus,  suddenly  blossomed  with  millionaires. 

191.  Distribution  through  stock  watering, — This 
chapter  is  not  to  deal,  however,  with  the  distribution  of 
surplus  through  its  effect  on  dividends  or  through  the 
final  sale  of  the  company's  assets,  but  rather  with  the 
more  direct  and  usual  methods.  First  among  these 
methods  to  be  mentioned  is  the  declaration  of  an  extra 
^tock  dividend.  In  the  year  1880  the  Chicago,  Rock 
Island  and  Pacific  Railroad  Company  was  a  highly  suc- 
cessful corporation  with  large  earning  power,  due  in 
part  to  the  fact  that  for  many  years  a  considerable  pro- 
portion of  the  earnings  had  been  put  back  into  the  prop- 
erty. The  directors  of  the  corporation  thought  it  wise 
to  increase  their  dividend  payments,  and  yet  on  account 
of  the  popular  prejudice  against  large  railroad  earnings 
did  not  wish  to  increase  the  dividend  rate.  They  there- 
fore adopted  the  plan  of  consolidating  with  themselves 
a  small  subsidiary  railroad,  the  stock  of  which  they  al- 
ready owned ;  they  paid  for  that  stock  and  for  the  stock 
of  the  Chicago,  Rock  Island  and  Pacific  Railroad  Com- 
pany by  an  immense  issue  of  stock  of  an  entirely  new 
corporation,  the  Chicago,  Rock  Island  and  Pacific 
Railway  Company.  This  stock  of  the  new  corpora- 
tion was  distributed  to  the  old  stockholders  in  the  pro- 
portion of  two  new  shares  to  one  old  share.  Then 
on  all  the  stock  outstanding  they  declared  and  main- 
tained a  dividend  rate  nearly  equal  to  what  had  pre- 
viously been  paid.  In  effect  this  process  was  a  capital-^ 
ization  of  a  surplus  of  the  corporation  and  a  distribution 


338  CORPORATION  FINANCE 

of  the  surplus  to  stockholders.     A  more  recent  instance  | 
of  somewhat  the  same  kind  is  the  well-known  Chicago 
and  Alton  deal,  which  is  discussed  in  Chapter  XXVII. 

The  essential  feature  of  such  a  transaction  is  the  cap- 
italization of  surplus  and  distribution  of  this  extra 
capitalization  to  stockholders.  The  reader  may  inquire 
as  to  the  advantage  of  this  course.  Surely,  he  will  say, 
two  shares  of  a  total  capital  stock  of  $2,000,000  are 
worth  no  more  than  one  share  of  a  total  capital  stock  of 
$1,000,000.  The  two  shares  in  the  first  instance^repre- 
sent  no^  larger  proportion  of  assets  and  earnings  than  ^. 
the  one  share  in  the  second  instance.  This  reasoning  is 
plausible  and  true  so  far  as  it  goes ;  yet  the  fact  remains 
that  the  stockholders  gain  something  by^a^tockdividend. 
In  the  first  place,  the  dividend  rate  is  kept  down  by^ 
this  means,  andjn  the  case  of  public  service  jcorporations 
public  hostility  is  to  some  extent  avoided,  In  other 
words,  jhe  stock  is  watered,  and  the  dividend  rate  main^ 
tained^  The  American  Telephone  and  Telegraph  Com- 
pany is  one  of  the  many  examples  of  companies  which 
have  thus  greatly  increased  their  capitalization  from  time 
to  time,  apparently  with  this  object  in  view.  A  discus- 
sion of  the  ethics  of  such  a  transaction  would  be  interest- 
ing, but  is  outside  the  scope  of  this  volume. 

In  the  second  place,  it  is  well  known  to  corporation 
managers  and  to  all  who  have  studied  the  stock  market 
with  any  care  that  two  shares  of  stock,  each  paying  4  per 
cent  per  annum,  will  have  a  comHnecLmarket  price 
higherjthan  one  share  of  stock  paying  8  per  cent  per 
annum.  This  seems  a  curious  anomaly,  but  isl"eadily 
explained.  There  are  more  people  able  and  willing  to 
buy  low-priced  than  there  are  to  buy  high-priced  se- 
curities. Therefore,  the  market  for_the  two_shares  in 
this  illustration  is  wider  than  the  market  for  the  one 


m 


DISTRIBUTION  OF  THE  SURPLUS  339 

share;  that  is  to  say,  the  demand  for  the  two  shares  is 
somewhat  greater  and  therefore  their  combined  price 
will  be  higher. 

This  same  principle  leads  the  promoters  of  mining 
and  oil  and  other  highly  speculative  companies  to  fix  the 
par  value  of  their  shares  at  a  low  figure,  $10  or  $1  or  10 
cents,  or  even  as  low  as  1  cent.  Applying  the  principle 
to  stock  dividends  we  see  that  there~may  be  a  real  gain 
to  a  stockholder  in  an  increase  in  the  number  of  shares^ 
he  holds,  even  tEpughTEef^^^  in  the  amount 

of  dividends  he  receives. 

192.  Distribution  through  subscription  privileges, — 
We  are  ready  now  to  discuss  the  most  common  and  im- 
portant method  of  distributing  a  surplus,  namely,  the 
granting  of_suEscriptionjprmle 

stock.  In  most  states,  as  the  reader  is  already  aware, 
stock  cannot  be  regarded  as  fully  paid  if  it  is  sold  for 
less  than  its  par  value.  No  state,  however,  makes  it 
obligatory  under  any  circumstances  to  sell  stock  at  more 
than  its  par  value;  yet  the  stocks  of  successful  corpora- 
tions which  are  able  to  maintain  stable  dividend  rates  of 
more  than  6  or  7  per  cent  per  annum,  almost  always 
iiave  market  values  higher  than  par.  Here  is  an  oppor- 
tunity for  the  corporation  directors,  if  they  see  fit,  to 
give  the  stockholders  a  valuable  privilege — the  privilege, 
namely,  ^  of  buying^jiew^ jto^jssues  at  less  than  the 
market  prices..  ^ 

The  relative  advantages  of  providing  funds  for  im- 
provements and  extensions  of  property  by  bond  issues, 
by  stock  issues  and  by  appropriations  from  earnings, 
have  been  discussed  in  Chapter  XXII.  It  was  there 
laid  down  as  a  general  principle  that  provision  of  per- 
manent capital  funds  by  means  of  stock  issues  is  not  ad^ 
yisabje  unkss^aUJ^  stock  is  taken  by^theojdjtock-^ 


S40  CORPORATION  FINANCE 

holders.  This  condition  will  be  fulfilled,  however,  when 
the  old^tockholders  are  givejijthe  valuable  privilege  of 
buying  the  new  stock  at  less  than  its  market  value,  and 
under  such  circumstances  the  raising  of  additional  capi- 
tal funds  by  stock  issues  is  a  very  common  and  on  the 
whole  cgmmendaWe  method.  We  have  now  to  consider 
exactly  how  surplus  may  be  distributed  by  means  of 
these  "privileged  subscriptions"  and  how  each  stock- 
holder may  best  secure  his  share  of  the  advantages  that 
should  accure  to  him. 

193.  An  opportunity  thus  given  for  cheap  investment. 
— The  privilege  of  buying  a  certain  amount  of  stock 
below  the  market  price  enables  the  stockholder,  if  he 
chooses,  to  make  a  new  investment  on  exceptionally 
favorable  terms.  For  instance,  in  1902  the  Illinois 
Central  Railroad  Company  put  out  a  new  stock  issue  and 
gave  to  its  stockholders  of  record  the  privilege  of  buy- 
ing the  new  stock  at  par  in  any  amount  up  to  20  per 
cent  of  their  stockholdings.  Thus  if  a  man  had  100 
shares  of  old  stock,  he  was  given  an  oportunity  to  buy 
20  shares  of  the  new  stock  at  par.  The  average  price 
of  Illinois  Cenfral  stock  during  the  six  months  follow- 
ing the  date  of  the  new  issue  was  156^/^,  thus  showing 
a  large  paper  profit  to  those  who  bought  the  new  stock. 
As  this  stock  was  then  paying  an  8  per  cent  dividend, 
those  who  bought  and  held  it  for  investment  were  get- 
ting much  more  than  the  usual  market  return  on  their 
investment. 

A  great  many  stockholders,  however,  do  not  carejtq 
increase _their  capital  investment,  but  prefer  to  take  their 
profits  at  once.  In  such  a  case  they  have  a  choice 
among  four  different  methods  of  securing  the  profits, 
as  follows: 

(a)  A  stockholder  may  buy  outright  the  proportion 


DISTRIBUTION  OF  THE  SURPLUS  341 

of  new  stock  allotted  to  him  as  a  speculation,  and  a 
little  later  at  some  favorable  opportunity  may  sell  it. 

(b)  He  may  sell  "short"  after  the  issue  of  new  stock 
is  announced  and  deliver  when  he  gets  his  quota  of  new 
stock 

(c)  Instead  of  selling  "short"  he  may  sell  outright 
an  amount  of  his  old  holdings  just  equal  to  the  amount 
of  new  stock  that  he  has  a  right  to  buy. 

(d)  He  may  sell  his  privilege  or  "right"  to  subscribe 
to  the  new  stock. 

It  will  be  well  to  compare  briefly  the  advantages  of 
these  four  methods. 

194.  Cashing  the  privilege, — The  subsequent  sale, — 
The  first-named  method  is  the  simplest,  but  not  gener- 
ally the  best.  The  chief  difficulty  is  that  the  stock- 
holder must  pay  cash  for  his  quota  of  the  new  stock; 
and  that  means  that  he  must  either  borrow  the  money 
or  must  lose  the  interest  on  some  of  his  own  funds. 
Frequently  the  subscriptions  to  the  new  stock  are  pay- 
able in  installments.  Therejomyjbe^ajperi^d  p£  severJ 
months  or  a  year  between  the  date  of  the  first  installment 
and  the  final  issue  of  the  stock.  For  many  stockholders 
it  may  prove  decidedly  inconvenient^itherjbo  use  their 
own  funds  or  to  borrow  money^  .  Another  disadvantage 
lies  in  the  well-known  fact  that  ^market  price  of  any 
stock  after  a  privileged  subscription  has  been  allotted 
to  it  almost  always  tends  downward.^  One  reason  ob- 
viously is  that  the  new  issue  increases  by  so  much  the 
total  amount  of  stock  outstanding;  the  second  reason 
is  that  after  a  "right"  has  once  been  granted,  investors 
figure  that  there  will  be  no  additional  rights  for  a 
number  of  years ;  a  third  reason  is  that  the  chief  men 
interested  in  a  corporation  that  is  about  to  put  out  a 
new  issue  and  the  underwriters  of  a  new  issue  will  usu- 


34g  CORPORATION  FINANCE 

ally  "buU"  the  previously  outstanding  stock  in  advance, 
in  order  to  create  a  good  demand  for  the  new  issue. 
Now  a  stockholder  who  follows  the  first  of  the  four 
methods  and  does  not  sell  his  stock  until  after  he  has 
paid  for  and  received  it,  will  probably  sell  on  a  falling 
jmarket  and  will  not  reap  as  much  profit  as  one  who 
follows  either  of  the  other  three  methods.  On  the  other 
hand,  it  must  be  said  for  this  first  method,  that  it  is  ab- 
solutely safe — a  statement  which  cannot  be  applied  to 
the  method  next  to  be  considered." 
^  195.  Cashing  the  privilege. — ''Short  selling/' — THe 
^^  mechanism  of  "short  selling"  has  already  been  treated 
in  Chapter  XVII.  In  the  case  immediately  before  us 
a  stockholder  who  had  the  right  to  subscribe  to  twenty 
shares  of  a  new  issue  might  deposit  a  margin  of  10  or  15 
per  cent  with  his  broker  and  instruct  him  to  sell  short. 
The  broker  borrows  the  twenty  shares  in  order  to  make 
delivery  and  keeps  on  borrowing  until  the  stockholder 
is  able  to  get  his  twenty  new  shares  from  the  corporation 
and  turn  them  over  to  the  broker  to  repay  the  borrowed 
stock.  Under  this  arrangement  the  stockholder  will  be 
more  likely  than  under  the  first  method  to  get  the  top 
market  price,  because  he  will  sell  immediately  after  a 
"right"  is  announced — sometimes,  if  he  has  inside  in- 
formation, even  before  such  announcement  is  made. 
This  method  further  makes  it  unnecessary  for  the  stock- 
holder to  borrow  any  money.  He  simply  turns  over  his 
rights  to  his  broker  who  uses,  in  order  to  pay  for  the 
new  stock,  the  money  that  he  has  received  from  the 
"short"  sale. 

All  this  sounds  very  easy  and  simple  and,  as  a  matter 
of  fact,  it  usually  works  out  all  right.  The  difficulty 
comes  in  the  fact  that  any  man  who  sells  short  runs  the 
risk  of  being  caught  in  a  bull  movement  of  that  stock 


DISTRIBUTION  OF  THE  SURPLUS  343 

or  even  in  a  "corner."  ^  The  reader  may  perhaps  sug- 
gest that  in  such  a  case  he  may  easily  make  delivery  from 
his  old  stock  and  thus  obviate  any  serious  loss.  The 
answer  here,  however,  is  that  probably  he  has  sold  short 
the  amount  of  his  old  stock  as  well  as  of  his  quota  of 
new  stock,  or  has  in  some  other  way  tied  up  the  old 
stock;  otherwise,  he  would  probably  follow  the  third, 
rather  than  the  second,  method.  Successful  corners  are 
not  very  common  in  Wall  Street  or  any  other  market. 
When  they  do  come,  however,  they  bring  disaster  and 
ruin  in  their  train. 
9  196.  Cashing  the  privilege, — Sale  of  old  stock. — The 
third  method  is  not  open  to  either  of  the  objections  that 
have  been  specified.  The  stockholder  is  much  more 
likely  to  get  the  best  market  price  than  under  the  first 
method;  he  is  not  involved  in  the  dangers  that  attach  to 
the  second.  He  picks  his  own  time  to  sell  and  from  the 
proceeds  of  the  sale  has  funds  enough  to  buy  the  same 
amount  of  new  stock  with  large  profits  in  addition.  The 
sale  of  part  or  all  of  jhe  stockholder^ shares  wilLnot 
impair  in  any  way  his  right  to  subscribe  to  the  new 
stock,  inasmuch  as  this  right  isLalways  granted  to  stock- 
holders of  record  on  a  given  day ;  it  makes  no  difference 
whether  the  stockholder  of  record  increases  or  decreases 
his  holdings  after  that  day.  The  only  fault  to  be  found 
with  this  method  is  that  it  is  not  practicable  for  all  stock- 
holders. A  great  many  of  them,  in  all  probability,  will 
have  their  holdings  posted  as  collateral  for  loans,  or  for 
some  other  reason  will  not  care  to  part  with  stock  even 
temporarily. 

197.  Cashing  the  privilege, — Sale  of  rights, — The 
fourth  method,  the  sale  of  "rights,"  is  the  next  best  plan 

1  The  meaning  of  the  term  "  corner  "  is  explained  in  the  Yplum?  On  In"- 

VESTMENT  AND  SPECULATION. 


SU  CORPORATION  FINANCE 

ordinarily  and  is  much  used  by  those  who  do  not  care 
either  to  increase  their  holdings  or  to  decrease  them  even 
temporarily.  It  is  customary  when  any  of  the  large 
corporations  give  their  stockholders  a  "subscription 
privilege"  to  a  new  stock  issue,  to  send  out  to  each  holder 
of  record  a  formal  statement  of  the  number  of  new 
shares  to  which  he  has  a  right  to  subscribe.  Such  doc- 
6usly  outstanding.  The  market  value  of  each  share^ 
uments  may  be  endorsed  and  transferred  in  the  same 
way  as  stock  certificates  and  are  bought  and  sold  on 
many  of  the  stock  exchanges  and  on  the  New  York 
Curb  Market.  ^Tiese  documents  are^ themselves  known 
as  "rights,"  just  as  certificates  of  ^tock  axe  loosely  called 
"stock."    "" 

As  was  stated  in  Chapter  XVII,  there  are  confusing 
differences  of  terminology  between  the  New  York  and 
some  of  the  other  stock  exchanges,  particularly  Phila- 
delphia. In  New  York  a  "right"  is  the  privilege  to 
subscribe  to  a  certain  amount,  usually  a  fractional  part 
of  a  share  of  new  stock.  A  stockholder,  therefore,  has 
as  many  "rights"  as  he  has  shares.  In  Philadelphia,  on 
the  other  hand,  a  '^ght"  means  the^privilege  afZhuying 
one  of  the  new  shares  of  stock.  To  illustrate,  suppose 
That  the  Lehigh  Valley  Railroad  Company,  whose  se- 
curities are  listed  on  both  exchanges,  should  issue  new 
stock  to  old  stockholders  at  less  than  the  market  price 
and  should  give  the  subscription  privilege  at  the  rate  of 
one  new  share  to  every  five  old  shares.  In  that  case  the 
holder  of  five  shares  would  have  one  "right"  to  dispose 
of  on  the  Philadelphia  or  five  "rights"  on  the  New  York 
Exchange.  Of  course  the  Philadelphia  "right"  would 
be  worth  five  times  as  much  as  the  New  York  "right." 
The  difference  is  merely  in  terminology. 

It  may  be  thought  that  the  third  and  fourth  methods 


DISTRIBUTION  OF  THE  SURPLUS  345 

would  yield  practically  the  same  returns,  but  this  is  an 
error.  The  third  method  is  almost  always  more  prof- 
itable, the  reason  being  that  there  is  a  much  broader 
demand  for  stock  than  there  is  for  "rights"  to  subscribe 
to  stock.  As  was  explained  in  Chapter  XVII,  there  is  a 
large  body  of  purchasers  not  directly  concerned  with  the 
stock  market,  who  are  constantly  taking  the  standard 
stocks  out  of  that  market  and  holding  them  for  perma- 
nent investment.  This  demand  does  not  exist  in  the  case 
of  "rights,"  because  few  people,  outside  of  those  whose 
business  it  is  to  know  such  things,  understand  how  the 
value  of  a  "right"  is  figured  or  even  what  it  is.  It 
would  often  be  greatly  to  the  advantage  of  these  per- 
manent investors  if  they  did  buy  "rights"  instead  of 
stock.  As  the  matter  now  stands,  however,  almost  the 
only  buyers  are  stock  brokers  and  their  immediate  fol- 
lowers who  buy  as  a  quick  speculation  in  the  hope  of 
making  a  quick  profit.  As  they  are  willing  to  buy  only 
in  case  they  think  they  are  getting  a  bargain,  it  follows 
that  the  price  of  rights  is  usually  less  than  it  should  be 
theoretically. 

198.  Theoretical  value  of  a  right, — Let  us  see  how 
the  value  of  a  right  should  in  theory  be  ascertained. 
The  reader  may  perhaps  have  jumped  at  the  conclusion 
that  the  value  would  be  the  difference  between  the 
market  price  of  the  old  stock  and  the  price  at  which  the 
new  stock  is  sold  to  stockholders.  This  is  incorrect, 
however,  because  it  fails  to  take  into  consideration  the 
change  in  the  value  of  each  share  brought  about  by  an 
increase  in  the  amount  of  stock  outstanding.  The  new 
stock,  it  must  be  remembered,  is  issued  at  less  than  the 
market  price,  and  does,  not,  therefore,  bring  to  the  com- 
pany's treasury  its  proportionate  amount  of  assets. 
For  this  reason  it  is  inevitable  that  the  market  price  of 


346  CORPORATION  FINANCE 

each  share  after  the  new  stock  has  been  issued  should  he 
less  than  it  was  before. 

To  illustrate  these  abstract  and  rather  vague  state- 
ments, take  the  case  previously  cited,  that  of  the  Illinois 
Central  Railroad,  which  in  August,  1902,  increased  its 
stock  20  per  cent  and  gave  to  each  five  shares  of  old 
stock  the  privilege  of  subscribing  to  one  new  share  at 
par.  The  market  price  of  the  old  stock  at  the  time  the 
rights  were  granted  was  about  170,  giving  a  premium, 
or  excess  above  par,  of  $70  per  share.  Now  there  is  to 
be  added  for  each  share  of  the  old  stock,  $20  in  assets, 
because  each  old  share  has  the  right  to  subscribe  to  one- 
fifth  of  a  new  share  at  par.  At  the  same  time  there  is  to 
be  added  $20  to  the  capital  stock  for  each  $100  previ- 
therefore,  after  the  new  stock  has  been  issued,  will  be 

y  =  158  2/6,    which   in   theory   would   be   the 

1^  market  price  of  each  share  after  the  new  stock  issue. 
As  a  matter  of  fact,  the  average  price  of  Illinois  Central 
shares  during  the  six  months  following  August,  1902, 
was  152  3-5.  The  value  of  the  "right"  belonging  to 
each  share  of  old  stock  would,  of  course,  be  in  this  case 
one-fifth  of  the  difference  between  par  and  the  market 
price  of  each  share  of  new  stock,  or  1-5  of  58  1-3,  ap- 
proximately 11  2-3. 

The  following  formula,  commonly  used  on  the  New 
York  Stock  Exchange,  gives  directly  the  theoretical 
value  of  a  right.  Let  P  represent  the  premium  on  the 
old  shares  and  R  represent  the  percentage  of  increase. 
Then  the  value  of  a  right  will  be  found  by  the  formula 

■p   \/  T> 

— -y^*    Applying  this  formula  to  the  Illinois  Central 

~     1  ij   I,         70  X. 2       14        ^^  ^^       . 

example,  we  would  have         ,    ^  ="  :ro~  "=  lX«o6.    As 

1  "T"  .ifi  l.Z 


DISTRIBUTION  OF  THE  SURPLUS  347 

has  been  stated  these  theoretical  prices  for  "rights"  are 
seldom  obtained  because  speculative  purchasers  of  rights 
are  not  willing  to  go  that  high.  Moreover,  there  are 
some  assumptions  underlying  these  mathematical  f orm- 
ulse  which  may  or  may  not  be  true.  It  is  assumed,  for 
instance,  that  the  stock  market  price  of  the  old  stock  is 
a  normal  price  uninfluenced  by  speculative  factors.  It 
is  assumed,  also,  that  the  company's  use  of  the  funds 
which  come  to  it  from  the  sale  of  new  stock  will  be 
neither  more  nor  less  remunerative  than  the  use  of  the 
capital  funds  previously  in  its  possession.  It  is  assumed, 
moreover,  that  the  market  price  after  the  new  stock  has 
been  issued  will  be  uninfluenced  by  speculative  factors. 
There  is  a  risk  in  all  these  assumptions,  as  the  profes- 
sional stock  market  trader  well -knows,  and  he  is  therefore 
unwilling  to  pay  the  full  theoretical  price  for  the  rights. 

Summing  up,  then,  we  may  conclude  that  of  the  four 
methods  of  securing  profits  from  privileged  subscrip-  ^ 
tions,  which  have  been  described,  the  third  method  is,  on  1 
the  whole,  likely  to  yield  the  largest  returns.  The 
second  method  comes  next  in  that  respect,  but  has  the 
disadvantage  of  being  dangerous.  The  fourth  method 
comes  next,  and  the  first  method  is,  on  the  whole,  least 
desirable.  It  will  not  do  to  accept  these  conclusions  as 
being  true  at  all  times  and  under  all  circumstances. 
They  are  merely  generalizations  based  on  experience. 

199.  Privilege  subscriptions  as  a  method  of  stock 
watering, — So  far  as  distribution  of  surplus  is  con- 
cerned, giving  "rights"  to  privileged  subscriptions  to 
new  issues  of  stock  produces  the  same  eff'ect,  though 
not  to  an  equal  degree,  as  a  stock  dividend.  The  assets 
of  the  company  in  proportion  to  the  number  of  shares 
are  diminished,  and  the  stockholder  gets  the  benefit. 
If  the  old  rate  of  dividends  is  maintained  on  all  the  stock 


348  CORPORATION  FINANCE 

outstanding  after  the  new  issue,  each  stockholder  may  be 
truthfully  said  to  have  come  into  possession  of  some  of 
the  company's  surplus.  The  privileged  subscription  is 
a  device  for  increasing  capitalization  without  propor- 

Jionately  jncrea^^^  assets^ ^lajbhat  sense  it  is  *  'stock 

watering." 

The  meaning  of  the  terms  "stock  watering"  and 
,  "overcapitahzation"  have  been  sufficiently  discussed  and 
need  not  be  given  further  attention.  It  is  enough  to 
r  reiterate  that  whatever  may  be  said  for  or  against  the 
1  practice  in  connection  with  public  service  corporations,  it 
I  is  in  private  corporations,  when  properly  used,  a  simple 
[,'and  legitimate  means  of  making  a  corporation's  capital- 
fization  correspond  to  its  earning  powers;  and  is  in  addi- 
jtion,  as  outlined  in  this  chapter,  a  legitimate  means  of 
j  transferring  to  the  stockholder  a  part  of  the  surplus 
which  his  company;  has  created  for  him. 


CHAPTER  KXV 

MANIPULATION  BY  CORPORATION  OFFICERS 

200.  Ought  we  to  study  manipulation? — So  far  we 
have  been  dealing  with  and  endeavoring  to  formulate 
the  principles  of  honest  and  efficient  corporate  manage- 
ment; the  rest  of  this  book  will  deal  with  dishonesty,  in- 
efficiency and  failure.  Sometimes  any  study  of  rascal- 
ity is  condemned  offhand  on  the  ground  that  it  may 
suggest  swindling  practices  to  persons  who  otherwise 
would  not  have  thought  of  them.  Perhaps  there  is 
something  to  be  said  in  favor  of  this  view ;  if  any  readers 
of  this  volume  feel  themselves  morally  weak  it  may  be 
well  for  them  to  omit  the  next  three  chapters.  On  the 
other  side  of  the  argument,  we  may  say  that  a  thorough 
knowledge  of  fraudulent  methods  does  not  by  any  means 
encourage  fraud,  for  it  reveals  that  almost  all  such 
methods,  however  cunning  they  may  appear,  are  un- 
sound and  dangerous.  Furthermore — and  this  is  the 
important  point — ^honest  men  ought  certainly  to  acquire 
as  clear  an  insight  as  they  can  into  the  methods  of 
swindlers  in  order  that  they  may  be  on  their  guard  and 
may  protect  themselves  and  those  who  are  dependent 
upon  them. 

201.  The  corporate  form  favors  manipulation, — The 
corporation,  as  practically  every  business  man  now  ap- 
preciates, is  for  most  concerns  the  most  convenient,  use- 
ful and  efficient  form  of  organization  that  has  yet  been 
devised.  It  is  likewise  true  that  the  corporation  so  far 
has  proved  itself  a  most  efficient  form  in  the  hands  of 

349 


350  CORPORATION  FINANCE 

rascals  for  transferring  other  peoples'  rightful  property 
into  their  own  pockets.  In  an  address  on  "Abuse  of 
Corporate  Privileges"  printed  in  the  American  Law 
Review  Mr.  Seymour  D.  Thompson  has  described  from 
the  lawyer's  point  of  view  the  present  conditions.  He 
says: 

Our  corporate  life  is  honeycombed  with  corruption.  A  cor- 
poration is  formed;  its  business  is  put  into  the  hands  of  cer- 
tain managers  holding  some  of  its  stock  and  expert  in  the  man- 
agement of  its  business.  Debts  are  created  and  the  managers 
become  the  creditors.  The  result  is  that  rings  are  organized 
within  rings,  wheels  within  wheels,  combinations  within  com- 
binations. The  managers,  in  the  character  of  creditors,  seize 
upon  and  foreclose  the  property  of  the  corporation,  and  by 
well-known  processes  squeeze  the  other  stockholders  out  and  be- 
come themselves  proprietors  with  larger  holdings  than  they  had 
before.  This  sweating  process,  dignified  by  the  name  of  fore- 
closing and  reorganizing,  has  come  to  be  a  regular  industry  in 
our  courts  of  justice.  Courts  of  justice  have  neither  the  time 
nor  the  means  to  take  upon  themselves  the  management  of  all 
the  corporations  in  the  country;  and  therefore  the  outraged 
and  complaining  stockholders  are  told  that  they  cannot  come 
into  court  until  they  have  exhausted  all  the  remedies  within  the 
corporation. 

.  202.  Is  manipulation  a  necessary  evil? — Now  this  de- 
plorable condition,  which  is  one  of  the  chief  evils  of  the 
American  business  world,  is  not,  fortunately,  a  necessary 
evil.  We  may  well  doubt,  indeed,  whether  the  lawyers 
with  their  quibbles  and  conservatism  will  do  much  to 
remedy  conditions.  But  we  may  expect  much  from  the 
growing  interest  of  the  public  in  corporate  affairs.  The 
evil  exists  chiefly  because  the  corporate  form  of  organ- 
ization is  still  a  thing  in  which  most  people  have  had  little 
experience  and  the  workings  of  which  they  do  not 


MANIPULATION  BY  CORPORATION  OFFICERS       351 

clearly  understand.  The  true  remedy,  then,  for  the 
evils  of  corporate  manipulation,  is  publicity  and  educa- 
tion. These  three  chapters  following,  which  constitute 
the  first  attempt,  so  far  as  the  author  knows,  to  classify 
and  describe  the  methods  commonly  used  for  defrauding 
some  of  the  owners  of  a  corporation  for  the  benefit  of 
others,  will  fulfill  their  chief  purpose  if  they  have  some 
slight  influence  in  checking  this  evil. 

Perhaps  the  words  "fraud"  and  "swindling"  in  the 
preceding  paragraphs  should  not  have  been  used;  they 
do  not  convey  exactly  the  conception  which  is  in  the 
author's  mind  in  writing  these  chapters.  We  are  not 
to  be  concerned  here  with  ordinary  clear  cases  of  fraud ; 
a  study  of  such  cases  belongs  to  law  rather  than  to 
finance.  Moreover,  a  clear-cut  instance  of  fraud  is  not 
usually  a  very  dangerous  thing,  because  the  victim  may 
seek  and  obtain  redress  in  the  courts.  The  chief  danger 
comes  not  from  crude  and  obviously  illegal  larceny,  but 
from  acts  that  cannot  be  proven  fraudulent  and  that 
belong  in  the  shadowy  borderland,  bounded  by  shrewd 
dealing  on  the  one  side  and  on  the  other  by  plain  swin- 
dling. Some  of  the  practices  to  be  described  are  allow- 
able, although  most  of  them  are  discredited  under  the 
rules  of  the  business  game  as  those  rules  are  generally 
interpreted. 

203.  Scope  of  the  chapters  on  manipulation, — It 
should  be  made  plain  also  at  the  beginning  that  in  these 
chapters  not  much  will  be  said  about  "malefactors  of 
great  wealth"  or  about  large  "predatory  corporations," 
although  some  of  these  corporations  furnish  shining 
examples  which  cannot  be  overlooked.  We  shall  deal 
rather  with  everyday  small  business  corporations  and 
with  those  kinds  of  manipulation  that  may  be  found  in 
every  section  of  the  country.     The  "sharks"  of  Wall 


S52  CORPORATION  FINANCE 

Street  do  not  by  any  means  have  a  monopoly,  as  some 
of  the  cases  to  be  cited  will  show,  on  dubious  finance. 

As  a  basis  of  classification  we  will  take  up  methods 
of  manipulation  under  the  four  heads: 

(a)  Manipulation  by  officials. 

(b)  Manipulation  by  directors. 

(c)  Manipulation  for  stockholders  as  a  body. 

(d)  Manipulation  for  controlling  stockholders. 

Of  course,  this  classification  is  not  exact.  We  shall 
find  constant  overlapping,  for  the  obvious  reason  that 
any  man  or  group  who  desires  to  manipulate  will  prob- 
ably try  to  make  their  control  as  complete  as  possible,  and 
will  work  through  stockholders'  meetings,  directors' 
meetings,  and  officers'  administration.  Nevertheless, 
this  classification  will  be  found  convenient  and  for  the 
present  purpose  sufficiently  accurate. 

204.  Exorhitant  salaries, — The  most  obvious  and 
common  method  by  which  a  corporation  official  may 
milk  a  corporation  of  its  profits  is  by  paying  himself  an 
exorbitant  salary.  This  is  a  practice  so  frequent  and  so 
easy  that  it  would  be  superfluous  to  cite  examples.  A 
corporation  official  cannot,  to  be  sure,  absolutely  fix  his 
own  salary,  for  that  power  is  reserved  to  the  directors. 
If  the  official,  however,  is  a  powerful  stockholder,  or  if 
two  or  three  officials  can  get  hold  of  a  majority  of  the 
stock,  or  if  an  official  can  bring  outside  pressure  to  bear 
upon  the  board  of  directors,  he  may  cause  a  salary  to 
be  allotted  to  him  far  in  excess  of  what  he  is  actually 
worth  to  the  company.  It  is  not  at  all  unusual  for 
minority  stockholders  in  small  corporations  to  be  de- 
prived of  profits  because  the  president,  or  other  official, 
who  owns  the  controlling  stock  raises  his  own  salary  as 
fast  as  profits  go  up.  It  would  be  very  difficult — prac- 
tically impossible — in  such  a  case  to  prove  fraud.     No 


MANIPULATION  BY  CORPORATION  OFFICERS     353 

court  would  undertake  to  say  that  a  salary  was  fraudu- 
lent, or  that  directors  were  acting  beyond  their  powers 
in  agreeing  to  it,  unless  the  salary  were  beyond  all 
reason. 

205.  Fraudulent  tontracts. — ^Another  favorite  method 
of  manipulation  by  officers  is  the  use,  or  rather  abuse, 
of  their  power  to  purchase  and  to  make  contracts  on 
behalf  of  the  corporation.  The  evil  of  purchasing  of- 
ficers being  in  league  with  the  firms  from  which  they 
buy  supplies  and  getting  a  rake-oiF  on  the  corporation's 
purchases,  has  been  so  much  exploited  as  to  make  un- 
necessary any  further  illustration.  There  is  no  question 
but  that  something  of  the  kind  does  go  on  in  many  of 
the  larger  corporations.  Yet  the  purchasing  agent  is 
generally  a  subordinate  official  whose  policy  is  closely 
scrutinized  by  his  superiors  and  who  is  subject  to  instant 
dismissal  if  any  strong  tendency  on  his  part  toward 
"grafting"  is  discovered.  His  delinquencies  are  not  so 
interesting  to  us  in  this  study  as  those  of  his  superiors. 
Let  us  examine  briefly  a  few  instances  in  which  high  cor- 
porate officials  have  misused  their  power  to  bind  the 
corporation. 

In  the  Illinois  courts  some  years  ago  suit  was  brought 
by  H.  P.  Killjoy,  a  stockholder,  against  the  Mandarin 
Brewing  Association.  He  alleged,  and  seems  to  have 
proved  to  the  satisfaction  of  the  court,  that  in  1896 
three  brothers  purchased  a  majority  of  the  stock  and 
obtained  control  of  this  brewing  corporation.  They 
elected  themselves  to  the  directorate  and  to  most  of  the 
corporation  offices.  One  of  the  brothers  owned  a  piece 
of  real  estate  which  the  corporation  purchased  at  an 
amount  alleged  to  have  been  far  in  excess  of  its  true 
value.  The  brothers,  as  directors,  paid  themselves  large 
salaries  as  officers  and  no  dividends  were  forthcoming 

1—23 


S54.  CORPORATION  FINANCE 

to  the  stockholders.  The  stockholders  were  kept  in 
ignorance  of  the  purchase  of  the  real  estate  and  of  the 
size  of  the  salaries.  Although  the  court  was  so  far 
convinced  of  the  truth  of  these  allegations  that  a  re- 
ceiver was  appointed  for  the  company,  no  criminal  or 
civil  action  was  taken  against  the  three  brothers. 

The  facts  cited  in  a  recent  case  in  the  Massachusetts 
courts  are  of  interest  in  this  connection.  Samuelson, 
defendant  in  the  case,  was  treasurer  of  the  Easton 
Ferry  Company.  He  sold  bonds  of  the  company  and 
neglected  to  account  for  them.  He  charged  the  com- 
pany for  bank  discounts  larger  than  the  bank  charged, 
claiming  that  this  extra  discount  was  for  his  own 
personal  indorsement,  which  appeared  on  the  notes. 
He  purchased  coal  in  his  own  name  at  a  low  price  and, 
as  treasurer,  bought  the  same  coal  for  the  company 
from  himself  at  a  high  price.  In  this  case  the  court 
ruled  that  Samuelson  should  be  charged  with  the  market 
value  of  the  bonds  that  he  had  sold  and  should  refund 
the  difference  between  the  market  price  of  the  coal  and 
the  price  at  which  he  had  purchased  it  from  himself 
for  the  company.  Here  again  there  was  no  hint  ofi 
criminal  liability  or  punishment. 

Take  another  case,  this  time  from  the  New  York 
courts.  Two  officers  of  a  paper  company  obtained  an 
option  to  purchase  a  manufacturing  plant  for  $75,000. 
The  same  plant  was  sold  to  the  corporation,  of  which 
one  of  the  defendants  was  president,  for  $100,000. 
The  deed  was  taken  directly  from  the  owner  of  the 
plant  to  the  corporation  reciting  a  consideration  of  $1. 
The  majority  of  the  stockholders  had  no  knowledge  of 
the  option  price  of  $75,000  until  later.  On  learning 
the  facts  they  elected  new  officers  who,  on  behalf  of  the 
company,  brought  suit  against  the  defendants  for  the 


MANIPULATION  BY  CORPORATION  OFFICERS      365 

difference  between  the  true  purchase  price  and  the  price 
charged  to  the  corporation.  The  suit  was  unsuccess- 
ful. 

As  this  is  not  a  legal  treatise,  a  discussion  of  the  exact 
legal  reasons  for  the  decisions  of  the  court  in  each  of  the 
three  cases  cited  is  not  necessary  here.  The  important 
feature  common  to  the  three  cases  and  common  to 
practically  all  similar  cases  is  that  in  the  present  state 
of  the  law  an  official  may  make  contracts  and  purchases 
directly  advantageous  to  himself  and  disadvantageous 
to  the  corporation  without  fear  of  punishment — pro- 
vided, of  course,  that  he  and  his  lawyers  make  no  legal 
blunders.  Assuming  that  he  avoids  this  pitfall,  the 
worst  that  can  happen  to  him  through  the  operation  of 
the  law  is  a  restitution  of  his  ill-gotten  gains,  which  is, 
of  course,  no  punishment  at  all.  His  true  punishment 
comes  simply  in  the  fact  that  sooner  or  later  his  dis- 
honesty will  be  discovered  and  his  reputation  among 
honorable  business  men  will  be  indelibly  smirched. 

206.  New  companies  for  profitable  business, — A  third 
method  by  which  corporation  officials  often  transfer 
an  undue  portion  of  corporate  profits  to  themselves  is 
by  the  formation  of  new  companies  for  profitable  busi- 
ness. Every  corporation,  whether  it  be  railroad,  in- 
dustrial, trading  or  financial,  will  find  some  features 
of  its  operations  more  profitable  than  others.  The 
ordinary  stockholder  may  not  know  anything  about 
the  actual  operation  of  the  business  or  about  the  oppor- 
tunities for  large  profits;  obviously  the  officers  who  do 
understand  the  situation  are  under  a  strong  temptation 
to  use  their  knowledge  for  their  own,  instead  of  for  the 
corporation's,  benefit. 

The  writer,  for  instance,  knows  of  a  company  of  con- 
siderable size,  which  is  in  the  business  of  buying  and  sell- 


856  CORPORATION  FINANCE 

ing:  domestic  rugs  and  carpets.  The  concern  began  to 
deal  in  a  small  way  in  oriental  rugs  and  Smith  and  Jones, 
the  president  and  office  manager,  respectively,  dis- 
covered at  once  that  in  their  town  this  business  was 
extraordinarily  profitable.  Instead  of  taking  hold  of 
the  business  and  developing  it  for  the  established  corpo- 
ration of  which  they  were  officers,  Jones  resigi^ed  his 
position,  organized  a  new  company,  in  which  Smith 
was  secretly  a  large  stockholder,  and  quickly  secured 
all  the  oriental  rug  trade  of  their  city  for  the  new  cor- 
poration. The  stockholders  of  the  first  corporation 
retain  Smith  as  their  president  to  this  day  and  regard 
him  highly  for  his  business  ability.  At  the  same  time, 
Smith  is  growing  rich  from  the  profits  of  the  new  cor- 
poration. The  stockholders,  even  if  they  knew  all  the 
facts,  would  not  be  justified  in  saying  that  they  had  been 
defrauded.  All  that  they  have  lost,  in  fact,  is  an  op- 
portunity. The  ethics  of  the  proposition  is  too  big  a 
question  to  be  here  discussed.  Whether  the  action  of  the 
officials  in  this  case  be  regarded  as  right  or  wrong,  it 
is  certainly  true  that  its  effect  was  to  transfer  possible 
profits  from  the  corporation  to  the  officers. 

Take  another  instance,  which  has  been  related  to  the 
writer  by  a  public  accountant.  The  Automatic  Door 
Fastening  Company  is  a  corporation  with  a  large 
capitalization.  It  controls  a  patent  device  that  can  be 
cheaply  manufactured  and  readily  sold  at  a  good  price. 
The  officers  easily  sold  the  stock  to  a  number  of  small 
investors  who  were  impressed  with  the  high  value  of 
the  patent  and  the  large  profits  which  would  certainly 
be  forthcoming  as  soon  as  it  was  put  on  the  market. 
The  corporation  secured  the  necessary  amount  of  capital 
funds,  and  manufactured  the  device;  at  this  point  the 


MANIPULATION  BY  CORPORATION  OFFICERS     357 

stockholders  learned  that  a  subsidiary;  corporation, 
owned  by  the  officers,  had  been  formed  in  each  section 
of  the  country  where  sales  were  expected  to  be  large  and 
that  every  subsidiary  corporation  had  a  hard  and  fast 
contract  with  the  parent  company  by  which  the  sub- 
sidiary company  got  the  device  at  a  price  that  barely] 
covered  the  cost  of  manufacture  and  was  given  exclusive 
selling  rights  in  its  own  section.  Practically  all  the 
profits  evidently  were  thereby  transferred  from  the 
corporation  to  the  subsidiary  companies. 

There  is  nothing  new  in  such  an  arrangement. 
Thirty-five  years  ago  when  the  numerous  short-distance 
railroads  of  the  United  States  were  first  being  consoli- 
dated into  systems,  railroad  officials  discovered  that  the 
most  profitable  traffic  was  that  which  moved  over  long 
distances.  It  was  not  long  after  this  discovery  before 
twenty-five  or  thirty  "despatch  lines"  and  "fast  freight 
lines"  were  in  existence,  each  of!  which  handled  the 
through  long-distance  traffic  over  two  or  more  railroads 
under  contracts  by  which  much  the  greater  portion  of 
the  large  profits  went  to  the  despatch  line  companies. 
It  is  almost  needless  to  add  that  the  chief  stockholders 
of  these  new  companies  were  railroad  officials. 

The  same  principle  was  applied  by;  Commodore 
Vanderbilt  when  the  New  York  Central  System  was 
formed  by  holding  in  his  own  hands  the  stock  of  com- 
panies which  owned  the  important  terminals  of  the 
railroad.  These  terminals  were  then  leased  to  the  New 
York  Central  on  terms  that  were  not  generally  exorbi- 
tant, but  that  nevertheless  yielded  a  large  return  to  the 
Commodore.  Although  the  Vanderbilt  family  for 
many  years  have  not  held  a  majority  or  anything  like 
a  majority^  of  the  New  York  Central  stock,  yet  they; 


358  CORPORATION  FINANCE 

have  been  able  to  dominate  the  management  of  that  road 
and  to  secure  for  themselves  large  profits  through  their 
ownership  of  these  terminal  companies. 

207.  Misuse  of  inside  information, — The  fourth 
method  of  milking  a  corporation  for  the  benefit  of  its 
ofiicers  is  by  making  use  of  "inside"  information.  This 
is,  on  the  whole,  the  safest  and  least  disreputable 
method.  Indeed  the  line  between  the  proper  and  im- 
proper use  of  the  information  that  necessarily  comes 
into  the  officers'  possession  is  so  indistinct  that  no  one 
has  yet  been  able  to  trace  it.  We  are  all  agreed,  no 
doubt,  that  it  is  quite  improper  for  the  president  of  a 
corporation  to  make  a  business  of  speculating  in  the 
stock  of  his  company,  especially  if  he  "sells  short"  and 
thereby  puts  himself  under  temptation  to  mismanage 
the  company.  On  the  other  hand,  probably  few  people 
would  raise  any  objection  to  an  officer's  investing  in 
some  shares  of  his  company's  stock,  if  he  has  good 
reason  to  believe  that  the  stock  is  selling  below  its  true 
value;  nor  does  there  seem  to  be  any  valid  objection  to 
his  selling  this  same  stock,  if  later  he  discovers  that 
speculative  forces  have  raised  it  far  above  its  true 
value.  Now  just  where  shall  the  line  between  what  is 
proper  and  improper  in  this  regard  be  drawn?  No  one 
can  say.  It  is  as  shadowy  as  the  line  between  specula- 
tive and  investment  buying. 

Whatever  doubt  there  may  be  as  to  whether  the  use 
of  inside  information  by  a  corporation  officer  to  guide 
his  buying  and  selling  of  stock  is  improper  or  not,  there 
can  certainly  be  no  question  but  that  the  use  of  such  in- 
formation by  an  officer  in  order  to  enrich  himself 
directly  at  the  expense  of  the  corporation  is  wholly  un- 
justifiable. The  three  cases  cited  below  are  fair 
examples  of  what  is  sometimes  done: 


MANIPULATION  BY  CORPORATION  OFFICERS      359 

(a)  An  officer  of  an  oil  refining  company  in  Pennsyl- 
vania, who  had  no  authority  to  sell  stock  for  the 
corporation,  received  a  buying  order  addressed  to  him- 
self as  an  official  of  the  corporation  for  5,000  shares 
at  20  cents  a  share.  He  filled  the  order  by  transferring 
5,000  shares  from  himself  to  the  purchaser  and  then 
took  for  himself  5,000  shares  of  treasury  stock  at  the 
special  price  of  2  cents  a  share.  In  this  case,  the  facts 
being  fully  proved,  the  court  ordered  a  refund  of  the 
difference  between  the  two  prices  to  the  corporation. 

(b)  The  XYZ  Manufacturing  Company,  with  capi- 
tal stock  of  $500,000,  one-half  paid  in,  went  into 
receivers'  hands.  The  company  had  notes  for  $20,000 
outstanding,  bearing  10  per  cent  interest  and  secured 
by  a  mortgage  on  its  property.  The  president,  know- 
ing the  condition  of  the  company,  just  before  the 
failure,  secured  the  notes  in  exchange  for  $30,000  face 
value  of  his  stock  in  the  company.  Ten  thousand 
dollars  was  paid  on  the  notes  when  they  fell  due,  but 
the  other  stockholders  objected  to  paying  the  remainder. 
The  president  transferred  his  claim  for  the  remaining 
$10,000  to  an  outsider  and  the  court  enforced  payment 
of  the  claim. 

(c)  Robinson,  the  treasurer  of  a  railroad  company, 
which  was  in  poor  condition,  bought  up  outstanding 
notes  of  the  company  at  a  large  discount  with  his  own 
money  and  as  treasurer  saw  to  it  that  the  notes  were 
paid  when  due  at  their  full  face  value.  The  court 
held  that  the  treasurer  had  done  nothing  illegal.  He 
was  at  liberty  to  buy  the  notes  for  himself,  as  he'  was 
under  no  obligation  to  buy  them  for  the  road.  He  could 
meet  them  when  due  with  the  road's  money,  as  that 
money  was  there  to  pay  any  or  all  of  the  road's  debts  and 
not  any  special  debt. 


860  CORPORATION  FINANCE 

The  strlkmgjf eature  of  these  three  cases,  as  in  several 
of  the  other  cases  cited,  is  that  although_the_^x)fficials 
were  obviously  unfaithful  to  their  trust  and  were  not 
acting  in  good  faith  as  agents  for  the  corporation,  never- 
theless they  were  able  to  escape  legal  punishment. 

208  Is  manipulation  by  officers  common? — The  four 
methods  that  have  been  given  and  illustrated,  by  which 
corporations  are  frequently  deprived  of  part  of  their 
just  profits  by  their  own  ofiicers  are: 

( a )  Exorbitant  salaries. 

(b)  Collusion  or  fraud  in  marketing,  purchases  and 
contracts. 

(c)  Formation  of  new  companies  for  especially 
profitable  business. 

Xd)  Misuse  of  confidential  information  which  comes 
to  ofiicers  by  virtue  of  their  position. 

It  would  certainly  be  a  gross  exaggeration  to  say  that 
all  or  a  majority  of  the  corporation  ofiicers  of  the  United 
States  are  guilty  of  any  of  these  practices.     On  the 
contrary,  it  is  probably  true  that  their  dealings  with  or 
for  the  corporation  which  they  serve  are  in  most  cases 
absolutely  honorable.     Yet  it  must  be  regretfully  ad- 
mitted that  these  four  methods  of  milking  a  corporation 
are  only  too  well-known  and  too  skillfully  practiced.    As 
an  accountant  of  wide  experience  says,  in  speaking  of 
.   corporate  manipulation  by  ofiicers,  "That  this  is  con- 
l  stantly  being  done  is  obvious  from  the  fact  that  so  many 
•    men,    drawing    salaries    with    large    corporations    of 
i    $10,000  to  $15,000  a  year,  become  millionaires  in  a  very 
short  period.     It  is  a  mere  matter  of  arithmetic  to 
demonstrate  that  this  is  not  done  out  of  the  money  that 
they  save." 


CHAPTER  XXVI 

MANIPULATION  BY  DIRECTORS 

209.  Usual  methods. — As  has  already  been  stated,  it 
is  difficult  to  draw  the  line  between  manipulation  by 
officers  and  manipulation  by  directors,  for  in  most  cases 
more  or  less  collusion  between  the  two  is  essential  to  the 
success  of  any  of  their  fraudulent  schemes.  It  is 
possible,  however,  to  draw  a  distinction  between  those 
forms  of  manipulation  which  are  primarily  intended  for 
the  benefit  of  officers  and  those  forms  which  are 
primarily  for  the  benefit  of  directors;  with  the  latter 
class  of  manipulative  methods  we  have  now  to  deal. 

The  method  that  was  given  the  first  place  in  our  con- 
sideration of  manipulation  by  officers,  namely,  exorbi- 
tant salaries,  is  not  worth  attention  here.  Directors, 
to  be  sure,  are  frequently  allowed  fees  for  attending 
meetings,  and  sometimes  these  fees  seem  to  be  somewhat 
excessive.  They  are  frequently  prescribed,  however,  in 
the  by-laws,  in  which  case,  of  course,  the  stockholders 
as  a  body  would  have  no  ground  for  complaint  against 
the  directors  as  a  body.  In  any  case,  the  fees  are  not 
large  enough  to  make  it  worth  while  for  the  directors 
to  attempt  to  defraud  the  stockholders  and  enrich  them- 
selves by  this  particular  method.  Without  much 
question  the  courts  would  set  aside  directors'  fees  for 
attending  meetings  much  higher  than  $10  to  $25  for 
each  meeting  and  would  look  with  suspicion  on  an 
especially  large  number  of  meetings. 

361 


362  CORPORATION  FINANCE 

Eliminating  this  possible  method  of  manipulation, 
then,  as  of  small  consequence,  we  may  set  down  four 
important  and  not  uncommon  means  of  transferring 
an  undue  proportion  of  a  company's  assets  and  profits 
to  the  pockets  of  its  directors.     These  four  methods  are : 

(a)  Fraudulent  purchases  and  contracts. 

(b)  Formation  of  new  companies  for  especially 
profitable  business. 

(c)  Deceiving  the  body  of  stockholders  by  means  of 
juggled  accounts. 

(d)  Forcing  the  corporation  unnecessarily  into  bank- 
ruptcy or  into  receivers'  hands. 

The  reader  will  observe  that  the  first  two  methods 
have  been  discussed  in  the  preceding  chapter.  There 
are,  however,  some  variations  that  should  be  mentioned 
between  the  application  of  these  methods  by  officers  and 
by  directors. 

210.  Fraudulent  contracts. — The  number  of  cases  of 
fraudulent  purchases  and  contracts  by  directors  that 
have  been  brought  before  the  courts  are  so  numerous 
that  it  is  difficult  to  make  a  selection.  The  following 
instances  are  typical: 

(a)  In  an  Alabama  case  the  facts  brought  out  were 
as  follows:  The  promoters  of  a  large  electric  manu- 
facturing company  obtained  as  a  profit  in  its  formation 
approximately  $2,000,000  of  stock  and  were  thereby 
able  to  exercise  considerable  influence  on  the  board  of 
directors.  The  directors,  in  spite  of  the  demands  of 
several  stockholders,  neglected  to  seek  to  recover  from 
the  promoters  any  portion  of  their  excessive  profit.  Suit 
was  brought  by  a  stockholder  to  compel  the  directors 
to  act  and  they  replied  that  they  deemed  the  proposed 
attempt  to  recover  inexpedient.  It  is  intimated  in  the 
court's  decision  that  they  were  improperly  influenced 


MANIPULATION  BY  DIRECTORS  363 

by  the  promoters  and  the  court  ordered  them  to  make 
the  attempt. 

(b)  Three  directors  of  a  corporation  formed  to  build 
a  sunmier  resort  hotel  caused  the  corporation  to  pur- 
chase the  land  on  which  the  hotel  was  to  be  located  from 
themselves  at  a  200  per  cent  profit  to  themselves.  The 
land  was  purchased  subject  to  a  heavy  mortgage. 
When  only  $25,000  had  been  subscribed  toward  the 
$90,000  required  to  erect  the  hotel,  the  directors  made 
a  contract  to  start  construction  of  the  building.  Their 
object  in  so  doing  was  to  enhance  the  value  of  other 
land  in  that  vicinity  which  they  owned.  The  corpora- 
tion became  insolvent  and  the  directors,  on  foreclosing 
their  mortgage  on  the  land,  virtually  became  the  owners 
of  the  land  and  of  as  much  of  the  hotel  building  as  had 
been  erected.  The  court  in  this  case  held  that  the  direc- 
tors were  liable  to  the  stockholders  for  the  depreciation 
in  the  market  value  of  the  stock. 

(c)  Two  of  three  directors  of  a  South  Dakota 
corporation,  for  the  purpose  of  securing  control  of  the 
corporation  for  themselves,  caused  the  issue  and  im- 
mediate sale  to  one  of  their  friends  of  a  large  amount 
of  new  stock  sufficient  to  give  the  two  directors  and 
their  friend  together  a  majority.  The  court  held  that 
as  the  friend  knew  all  the  facts,  the  sale  of  the  stock 
conferred  no  rights  upon  the  purchaser.  It  may  be 
inferred  from  this  decision  that  if  the  purchaser  had 
been  an  innocent  party,  the  transaction  would  have 
been  valid. 

(d)  In  a  somewhat  similar  instance  in  New  York 
a  full  board  of  directors  authorized  the  issue  of  sixty- 
seven  shares  of  stock  to  increase  its  capital.  The  presi- 
dent of  the  company  reported  at  a  subsequent  meeting 
that  he  had  received  no  subscriptions,  and  four  of  the 


364.  CORPORATION  FINANCE 

seven  directors  thereupon  took  the  stock  without  knowl- 
edge of  the  holder  of  the  majority  of  stock  previously 
issued,  who  was  also  a  director.  In  this  case  the  court 
allowed  the  purchasers  to  hold  and  vote  the  stock,  but 
enjoined  them  from  using  it  to  the  injury  of  the  pre- 
vious majority  holder. 

(e)  A  railroad  company  was  organized  in  Minnesota 
to  build  a  local  road  in  that  state.  Capital  stock  of 
$2,000,000  and  bonds  to  the  extent  of  $1,500,000  were 
authorized.  A  director  and  owner  of  a  majority  of  the 
outstanding  shares  drew  up  a  contract  with  the  XYZ 
Construction  Company  under  which  the  company  was 
to  build  the  road  and  receive  331  shares  of  its  capital 
stock  together  with  first  mortgage  bonds  to  the  amount 
of  $20,000  per  mile.  The  XYZ  Construction  Company 
then  made  a  contract  on  its  own  account  with  the 
firm  of  A  &  B,  under  which  the  firm  was  to  pay  $5,446 
for  each  $20,000  block  of  bonds  and  in  addition  was  to 
furnish  the  material  necessary  to  build  the  road.  The 
director  above  referred  to  was  interested  with  A  &  B 
and  was  to  receive  for  himself  an  agreed  share  of  the 
railroad  bonds.  The  actual  cost  of  construction  was 
to  be  about  $14,000  a  mile.  The  contract  came  before 
the  board  of  directors  and  two  directors,  whom  we  will 
call  Smith  and  Jones,  voted  for  the  contract  with  the 
understanding  that  they  also  were  to  become  interested 
with  A  &  B  and  to  receive  a  portion  of  the  profits. 
Afterwards  they  offered  to  contribute  one-fourth  of  the 
cash  required  for  actual  construction  of  the  road 
in  order  to  become  partners  with  A  &  B.  Their 
offer  was  refused.  They  then  brought  suit,  exposed 
the  whole  transaction  and  asked  to  have  the  contracts 
declared  void  for  fraud.  The  court  held  that  there 
was  no  fraud  on  the  face  of  the  transaction  but  that 


MANIPULATION  BY  DIRECTORS  365 

fraud  could  plainly  be  inferred,  inasmuch  as  the  cor- 
poration was  made  to  pay  more  than  was  necessary  for 
contruction.  They  held,  however,  that  the  two  direc- 
tors. Smith  and  Jones,  having  knowledge  of  the  trans- 
action, did  not  come  into  court  with  "clean  hands"  and 
could  not  cry  fraud  because  they  lost  what  they  had 
attempted  to  gain.  The  contract,  therefore,  was  noi 
set  aside. 

211.  Attitude  of  the  courts. — These  illustrations, 
taken  almost  at  random,  indicate  what  opportunities  for 
fraudulent  manipulation  are  open  to  corporate  directors 
and  how  slight  is  the  danger  of  legal  punishment.  As 
may  be  observed  over  and  over  again,  the  courts  assume 
that  a  corporation  is  honestly  managed  in  accordance 
with  the  wishes  of  the  stockholders  unless  the  contrary 
is  absolutely  proved.  Stockholders  who  object  to  the 
contracts  and  purchases  made  by  their  directors  are 
apt  to  be  told  that  their  true  remedy  is  to  elect  a  new 
board. 

Obviously  this  principle  of  the  law,  however  far  from 
applicable  it  may  be  in  particular  cases,  works  out,  on 
the  whole,  for  the  good  of  the  greatest  number.  Most 
corporations  are  honestly  managed.  Directors  are 
rightly  believed  generally  to  have  a  far  more  extensive 
knowledge  of  the  affairs  of  the  corporation  and  of  the 
contracts  and  purchases  that  should  be  made  than  the 
body  of  stockholders  have.  The  courts,  therefore, 
ordinarily  do  not  desire  to  set  aside  contracts  made  by 
the  directors  or  even  by  investigation  to  cast  doubt  upon 
those  contracts.  The  attitude  of  the  courts,  it  must  be 
admitted,  is  correct.  On  the  other  hand,  as  the  in- 
stances given  above  plainly  indicate,  it  is  also  true 
that  this  attitude  gives  directors  almost  unlimited  op- 
portunities  for   fraudulent   manipulation.     The    onl^ 


366  CORPORATION  FINANCE 

practicable  remedy  in  the  long  run  is  for  the  stockholders 
to  be  exceedingly  careful  to  elect  men  of  proved 
probity  to  their  directorate. 

212.  New  companies  for  profitable  business, — The 
second  method  of  manipulation  by  directors  that  has 
been  named  is  the  formation  of  new  companies  for 
profitable  business.  A  few  typical  illustrations  will  best 
explain  the  working  of  this  method. 

(a)  The  directors  of  a  New  York  building  and  loan 
association,  the  charter  of  which  required  the  funds  to 
be  invested  in  first  mortgages,  nevertheless  bought  some 
second  mortgages.  The  association  became  insolvent 
and  receivers  were  appointed.  Some  of  the  directors 
then  organized  a  realty  company  which  took  from  the 
receivers  the  land  and  buildings  owned  by  the  associa- 
tion at  50  cents  on  the  dollar  and  made  part  payment 
with  additional  second  mortgages.  The  directors  thus 
secured  for  themselves  at  small  cost  most  of  the  valuable 
assets  of  the  association.  The  court  discharged  the  re- 
ceiver and  appointed  another  receiver  to  conserve  the 
remaining  assets. 

(b)  The  Strong  Lumber  Company  and  the  Hoffman 
Manufacturing  Company  elected  three  men,  consti- 
tuting a  majority  of  both  boards,  directors  of  both  com- 
panies. The  HoflTman  Manufacturing  Company, 
which  had  the  better  credit,  accepted  time  drafts  drawn 
upon  them  by  the  Strong  Lumber  Company,  although 
no  consideration  had  been  given.  To  secure  themselves 
from  personal  liability  the  three  men  as  directors  of  the 
Strong  Company  placed  a  mortgage  on  the  property 
of  that  company  and  issued  bonds  which  were  turned 
over  to  the  Hoffman  Company.  When  the  facts  were 
presented,  the  court  entered  a  decree  setting  aside  the 
mortgage. 


MANIPULATION  BY  DIRECTORS  367 

(c)  The  directors  of  a  railroad  company  in  Nevada 
were  members  of  a  syndicate  which  intended  to  build 
a  connecting  road.  The  road  was  built  and  paid  for 
by  the  syndicate  and  was  mortgaged  heavily.  The 
^  syndicate  received  all  the  bonds  and  stock  and  then 
transferred  51  per  cent  of  the  stock  to  the  railroad  com- 
pany, of  which  they  were  directors,  in  consideration  of 
this  company's  guaranteeing  the  bonds.  The  guar- 
antee of  the  bonds  allowed  the  syndicate  to  sell  them  at 
a  good  price.  The  court  held  that  allegations  of  fraud 
were  not  sustained  and  that  the  whole  transaction  was 
legitimate. 

In  the  last  two  cases  the  profit  to  the  directors  evi- 
dently came  in  the  form  of  increased  credit  for  companies 
in  which  they  were  interested.  It  seems  clear  in  both 
cases  that  there  was  no  corresponding  advantage  to  the 
corporation ;  otherwise  the  corporation  in  each  case  would 
have  made  the  arrangement  on  its  own  account.  The 
reader  will  observe,  no  doubt,  that  directors  have 
opportunities  of  the  same  kind  as  those  which  fall  to 
officers,  when  it  is  discovered  that  some  particular 
feature  of  a  company's  business  is  especially  profitable. 
Either  the  directors  or  the  officers,  or  both  together,  may 
organize  a  new  company  of  their  own  to  handle  that 
business  and  thus  may  divert  profits  to  themselves. 

213.  Juggling  accounts. — The  third  means  open  to 
directors,  who  wish  to  manipulate  corporate  affairs  for 
their  own  interests,  is  to  tamper  with  the  corporation's 
books  and  thus  give  the  stockholders  a  wrong  impression 
as  to  the  company's  condition.  The  methods  that  may 
be  used  to  accomplish  this  object  are  so  numerous  and 
so  complicated  that  it  would  be  impracticable  to 
enumerate  all  of  them  here.  Indeed,  this  section  of 
our  subject  belongs  to  accounting  rather  than  to  finance. 


368  CORPORATION  FINANCE 

^A  few  typical  instances,  however,  which'  have  been 
supplied  by  some  of  the  most  experienced  and  best 
known  public  accountants  in  the  United  States  to  the 
writer,  may  be  enumerated.  The  reader  will  find 
further  light  on  this  important  subject  in  the  volume 
on  Auditing. 

(a)  The  directors  of  a  holding  company,  which 
owned  the  entire  stock  of  four  separate  manufacturing 
companies,  desired  to  present  a  favorable  report  of  the 
year's  operations  to  their  stockholders.  In  order  to 
do  so  they  took  into  account  dividends  paid  by  three 
of  the  companies  and  ignored  altogether  a  very  heavy 
loss  incurred  by  the  fourth  company.  Their  excuse  for 
so  doing — ^which  excuse,  however,  carries  very  little 
weight — was  that  the  holding  company  as  a  stockholder 
in  the  other  companies  was  entitled  to  the  benefit  of  all 
the  dividends  declared,  but  could  not  be  called  upon  to 
make  up  any  loss  that  might  be  sustained;  this  excuse 
obviously  overlooks  the  fact  that  the  loss  incurred  by 
the  fourth  company  constituted  a  diminution  of  the 
assets  of  the  holding  company.  A  firm  of  certified 
public  accountants  was  called  upon  to  sign  the  mislead- 
ing report  prepared  by  the  directors.  The  accountants 
were  given  access  to  the  books  of  the  holding  company 
but  were  refused  the  books  of  the  subsidiary  companies. 
The  firm  lost  the  audit,  which  went  to  more  pliable 
accountants  (not  holding  the  degree  of  certified  public 
accountant),  and  the  original  report  was  presented  to 
the  stockholders.  Presumably  the  directors  seized  the 
opportunity  to  sell  their  stock  in  the  holding  company 
at  a  high  price.  At  any  rate,  the  holding  company 
went  into  bankruptcy  not  long  afterwards. 

(b)  A  railroad  company,  when  the  time  for  the  annual 
report  and  audit  approached,  deliberately  withheld  the 


MANIPULATION  BY  DIRECTORS  369 

intertrafflc  claims  of  other  companies,  amounting  to  a 
considerable  sum,  by  simply  pigeon-holing  the  docu- 
ments and  not  recording  them  as  a  part  of  their  current 
obligations.  This  action  was  taken,  it  is  stated,  by  order 
of  the  executive  committee  of  the  board  of  directors,  who 
were  about  to  ask  authority  for  a  new  stock  issue  and 
who  desired  to  bring  out  the  issue  shortly  after  the 
annual  report  appeared.  The  certified  public  account- 
ants, who  had  charge  of  the  annual  audit,  in  this  case 
discovered  the  deception  through  a  general  analytical 
study  of  the  year's  operations  whereby  it  was  seen  that 
while  such  intertraffic  claims  ought  to  exist,  they]  were 
not  in  evidence. 

(c)  An  industrial  company  was  enabled  to  maintain 
a  market  value  for  its  stock  through  the  payment  of 
unearned  dividends  out  of  capital.  The  deficit  was  not 
shown  on  the  books  and  was  not  known  to  the  stock- 
holders until  after  an  audit  by  public  accountants.  Its 
existence,  however,  should  have  been  known  to  the 
directors  and  in  all  probability  was  known  during  the 
period  in  which  unearned  dividends  were  declared.  In 
this  case  judgment  was  obtained  in  the  courts  against 
the  directors  and  restitution  of  the  unearned  dividends 
was  obtained. 

(d)  In  a  case  brought  in  the  federal  courts  stock- 
holders asked  for  the  cancellation  of  stock  alleged  to 
have  been  fraudulently  and  secretly  issued  by  the  board 
of  directors.  It  was  stated  that  a  person,  to  whom  the 
certificate  was  issued  without  consideration  to  the  com- 
pany, executed  to  one  of  the  directors  a  power  of 
attorney  authorizing  him  to  vote  the  stock  and  delivered 
the  certificate  signed  in  blank.  Thus,  although  no 
transfer  appeared  on  the  books  of  the  corporation,  the 
stock  was  actually  owned  and  voted  by  one  of  the 

1—24 


370  CORPORATION  FINANCE 

directors.  As  the  stock  of  this  corporation  was  widely 
scattered  and  as  the  reports  to  stockholders  were  frag- 
mentary and  misleading,  the  whole  transaction  would 
have  passed  unnoticed  if  it  had  not  been  accidentally 
revealed  to  one  of  the  stockholders.  The  court  in  this 
ease  merely  cancelled  the  certificate  in  question  and 
neither  civil  nor  criminal  liability  was  found  to  attach 
to  the  directors. 

214.  An  accountant's  observations, — A  certified  pub- 
lic accountant,  whose  experience  in  handling  such  cases 
has  been  exceptionally  large,  has  been  kind  enough  to 
sum  up  for  the  writer  the  results  of  his  observations  in 
the  following  note : 

The  methods  employed  for  the  purpose  of  giving  a  wrong 
impression  to  the  stockholders  or  the  public  as  to  the  company's 
condition  as  shown  by  the  published  balance  sheet  are  almost  in- 
numerable, but  I  will  cite  a  few. 

Where  the  accounts  are  subject  to  audit  and  it  is  desired 
to  make  a  good  appearance  at  the  date  of  the  balance  sheet,  the 
practice  of  borrowing  a  large  sum  of  money  from  brokers  or 
bankers  for  a  few  days  is  often  resorted  to.  By  this  means  at 
the  date  of  the  balance  sheet  the  company  has  apparently  a 
large  amount  of  available  funds,  though  in  point  of  fact  the 
loan  is  repaid  a  few  days  later.  In  the  same  way,  where  such  a 
corporation  as  a  loan  and  investment  company  finds  itself  hold- 
ing securities  of  a  speculative  character,  such  as  mining  stock, 
it  is  quite  customary  to  make  a  sale  of  these  securities  to  brokers 
a  few  days  before  the  date  of  the  balance  sheet,  with  the  under- 
standing that  the  company  is  to  repurchase  them  at  the  same 
price  less  commission  for  the  accommodation  a  few  days  later. 
In  this  way  the  company  avoids  showing  on  its  published  bal- 
ance sheet  any  investments  that  are  not  of  a  gilt-edged  charac- 
ter, and  in  both  the  instances  quoted  above  it  is  very  hard  for 
the  auditor  to  find  any  grounds  for  refusal  to  give  an  unquali- 


MANIPULATION  BY  DIRECTORS  371 

fied  certificate  to  the  balance  sheet ;  the  condition  is  as  stated  by 
the  accounts  at  the  particular  date  at  which  they  are  drawn  up. 

Again,  where  it  is  desired  to  conceal  from  stockholders  the 
fact  that  the  company  is  making  large  profits  or,  on  the  other 
hand,  incurring  heavy  losses,  the  valuation  placed  upon  invest- 
ments in  stocks  and  bonds  of  other  corporations  or  the  valua- 
tion placed  upon  merchandise  on  hand  is  often  juggled,  the 
officers  of  the  company  constituting  themselves  the  arbiters  as 
to  what  is  really  the  actual  value  of  such  assets. 

Another_window-dressing_plan  often  employed  is  to  treat 
the  balances  due  on  current  account  from  the  branch  houses  of 
the  corporation  as  though  they  were  accounts  receivable  due 
from  ordinary  customers.  Goods  on  consignment  are  often 
similarly  treated  as  though  they  were  accounts  receivable  and 
included  in  the  balance  sheet  at  sale  price  under  this  caption  in- 
stead of  at  cost  price. 

215.  Remedies  for  this  kind  of  manipulation, — ^What 
little  has  been  said  here  with  regard  to  juggling 
accounts  by  directors  is  sufficient  to  drive  home  at  least 
one  truth,  namely,  that  the  only  safety  for  stockholders 
lies  in  insisting  upon  frequent  and  thorough  examina- 
tions by  certified  public  accountants  of  the  highest 
standing.  The  chief  asset  of  a  public  accountant  is  his 
unquestioned  reputation  for  penetration  and  integrity. 
The  loss  of  that  reputation  means  the  loss  of  his  profes- 
sional standing  and  of  his  clientele.  He  has,  therefore, 
the  strongest  motive  to  lay  bare  the  true  condition  of 
any  corporation  which  he  is  called  upon  to  examine  and 
to  state  the  exact  facts  to  the  stockholders.  The  stock- 
holders may  safely  place  confidence  in  him — ^unless,  to 
be  sure,  he  happens  to  be  one  of  those  black  sheep,  a  few 
of  whom  find  temporary  employment  in  all  professions. 

In  England  it  is  customary  for  the  stockholders  them- 
selves to  elect  a  public  accountant  to  serve  as  the  annual 


S7%  CORPORATION  FINANCE 

auditor  of  their  company.  It  will  be  a  fortunate  day 
for  American  stockholders  when  this  practice  becomes 
prevalent  also  in  this  country.  We  may  lay  it  down  as 
a  general  principle  that  officers  and  directors  who  are 
worthy  of  their  trust  will  not  object  to  having  their 
operations  scrutinized  at  least  once  a  year  by  an  impar- 
tial and  absolutely  independent  expert. 

Another  tendency  which  works  indirectly  toward  the 
same  result  is  the  growing  demand  on  the  part  of  the 
people  of  the  United  States  for  publicity  in  corporation 
affairs.  The  demand  for  publicity  is  especially  eiFec- 
tive  in  the  case  of  railroads  and  other  public  service 
corporations,  most  of  which  are  now  required  to  render 
complete  annual  reports  either  to  the  Interstate  Com- 
merce Commission  or  to  some  corresponding  state 
authority.  The  primary  purpose  of  this  requirement  is 
to  obtain  information  that  will  aid  legislatures  and  com- 
missions in  deciding  upon  reasonable  rates  and  prices. 
It  is  doubtful,  in  the  opinion  of  the  writer,  whether  this 
result  will  be  achieved.  There  can  be  no  question,  how- 
ever, but  that  the  interests  of  stockholders  of  such 
companies  have  been  greatly  advanced  by  a  general 
adoption  of  this  requirement.  It  is  now  possible  for  an 
investor  to  obtain  such  a  complete  and  authoritative  ' 
knowledge  of  the  interior  affairs  of  the  principal 
American  railroads  as  to  make  possible  an  intelligent 
judgment  of  the  honesty  and  efficiency  of  the  manage- 
ment. 

Seeing  the  advantages  that  are  thus  gained,  the 
stockholders  of  other  large  corporations  are  insisting 
more  and  more  forcibly  on  a  similar  pubUcity  and  in- 
vestors are  refusing  to  buy  the  securities  of  companies 
which  do  not  present  satisfactory  annual  reports.  That 
this  attitude  is  making  itself  felt  is  evident  from  the 


MANIPULATION  BY  DIRECTORS  373 

numerous  conversions,  referred  to  in  Chapter  XVII, 
of  securities  quoted  on  the  New  York  Stock  Exchange 
from  the  unhsted  to  the  listed  department. 

216.  Inflicting  loss  on  the  corporation, — The  fourth 
important  method  of  manipulation  by  directors  is 
through  forcing  heavy  losses  and  frequently  even  bank- 
ruptcy on  their  companies.  Here  again  a  few  examples 
selected  from  a  mass  of  cases  which  the  writer  has  exam- 
ined will  best  illustrate  the  principal  variations  of  this 
method. 

(a)  The  G.  and  R.  Railroad  Company,  a  Kentucky 
corporation,  constructed  a  road  from  Graceton  to 
Rawlings  for  which  it  was  heavily  indebted.  Robinson, 
a  director,  with  the  assistance  of  other  directors,  used 
the  profits  of  the  road  to  make  improvements  and  thus 
made  impossible  the  payment  of  interest  on  the  outstand- 
ing bonds.  The  company  was  thus  forced  into  bank- 
ruptcy and  at  the  bankrupt  sale  all  the  property  and 
rights  were  sold  to  Robinson.  Robinson  and  others 
then  formed  a  new  corporation  to  hold  the  road.  Five 
years  later  the  stockholders  of  the  bankrupt  corporation 
brought  suit  against  the  heirs  of  Robinson  to  have  the 
court  adjudge  the  road  as  held  in  trust  for  the  G.  and 
R.  Railroad  Company.  The  court  found  that  Robinson 
had  violated  his  duties  of  trust  by  willfully  mismanag- 
ing the  road  and  misappropriating  the  earnings  and, 
therefore,  returned  the  property  to  the  original  stock- 
holders, compensation  being  allowed  to  Robinson's 
heirs  for  the  amount  actually  paid  by  Robinson  for  the 
road.  Evidently  Robinson's  actions  in  this  instance, 
although  finally  declared  unlawful,  woilld  have  passed 
unchallenged  but  for  the  enterprise  and  persistency  of 
one  or  two  of  the  stockholders. 

(b)  In  a  recent  case  in  the  federal  courts,  certain 


874  CORPORATION  FINANCE 

trustees  of  a  building  and  loan  association  sold  a  valu- 
able piece  of  real  estate  to  a  trust  company,  in  which 
some  of  the  trustees  were  also  interested,  in  exchange 
for  securities  of  doubtful  value.  A  mortgage  on  the 
real  estate  was  taken  from  the  trust  company  as  a 
guarantee  that  the  securities  would  realize  the  price 
agreed  upon  for  the  property,  but  by  agreement  the 
mortgage  was  not  recorded.  Later  the  trust  company 
desired  to  sell  the  property  and  the  trustees  passed  a 
resolution  authorizing  the  cancellation  of  the  mortgage, 
and  it  was  cancelled  without  the  knowledge  or  consent  of 
the  stockholders.  Shortly  afterwards  the  trust  com- 
pany became  insolvent,  the  securities  held  by  the  build- 
ing and  loan  association  were  found  to  be  worthless  and 
next  to  nothing  was  obtained  for  the  property  that  had 
been  sold.  This  may  be  taken  as  a  typical  instance 
of  loss  willfully  inflicted  on  a  corporation  by  its  own 
directors. 

(c)  A  corporation  was  indebted  to  its  directors  and 
they  caused  mortgage  bonds  to  be  issued  to  them  for 
the  indebtedness.  The  bonds  were  immediately  as- 
signed to  a  rival  corporation.  Before  anything  further 
had  been  done  the  stockholders  learned  of  this  trans- 
action and  brought  a  suit  for  damages.  The  court  held 
that  the  directors  would  be  personally  liable  for  what- 
ever consequences  of  their  acts  might  affect  injuriously 
the  interests  of  non-consenting  stockholders. 

(d)  A  stockholder  of  a  Montana  mining  corporation 
in  an  action  alleged  that  officers  and  directors  in  pur- 
suance of  a  plan  to  depreciate  the  company's  stock,  in 
order  to  render  practically  worthless  stock  held  by  the 
plaintiff  and  others  similarly  situated,  refused  to  sell 
treasury  stock  of  the  corporation  in  order  to  procure 
funds  with  which  to  prosecute  assessment  work  on  the 


MANIPULATION  BY  DIRECTORS  375 

company's  mining  claims  essential  to  compliance  with 
the  state  and  federal  laws.  Further  the  directors  sys- 
tematically depreciated  the  value  of  the  treasury  stock 
by  words  and  actions,  refused  to  accept  money  offered 
therefor,  removed  the  books  of  the  company  from  the 
state,  declined  to  give  the  plaintiff  any  information  re- 
garding the  company's  affairs  and  in  general  so  con- 
ducted its  business  as  to  destroy  the  value  of  its  shares. 
Their  object  in  so  doing  was  to  make  it  necessary  for 
the  company  to  give  up  its  mining  claim  in  order  that 
they  might  re-locate  the  property  in  their  own  names. 
In  this  case  the  court  decided  that  fraud  had  been 
sufficiently  shown  and  placed  a  receiver  in  charge  of  the 
property.  The  decision,  however,  would  not  have  been 
reached  except  for  certain  imprudent  remarks  on  the 
part  of  some  of  the  directors. 

217.  The  danger  in  losing  control  of  a  corporation, — 
The  most  interesting  instance  that  has  come  to  the 
writer's  notice  is  given  by  a  certified  public  accountant 
in  one  of  the  Western  States,  who  vouches  for  its  being 
a  typical  and  actual  case  of  manipulation  by  directors. 
He  writes  as  follows: 

A  owned  a  majority  of  the  capital  stock  outstanding  in  a 
manufacturing  concern.  Besides  himself  he  had  two  dummies 
for  the  two  other  members  of  the  board  of  directors.  B  de- 
sired to  buy  an  interest  in  the  concern  and  bought  less  than  half 
of  A's  stock  (leaving  A  still  in  control),  with  the  understanding 
that  B  was  to  become  a  member  of  the  board  of  directors,  and 
that  A  and  B  should  select  another  person  whom  they  might 
interest  at  some  future  date  when  selling  more  stock.  There- 
fore, they  mutually  decided  to  place  a  dummy  temporarily  on 
the  board.  B  is  a  crook,  as  develops  afterwards.  C  (the 
agreed-upon  dummy)  proves  to  be  a  bigger  crook  than  B,  thus 
giving  B  a  majority  in  the  board  of  directors.  After  this  ar- 
rangement has  been  carried  through,  B  and  C  trump  up  some 


376  CORPORATION  FINANCE 

imaginary  charges  against  the  methods  of  management  of  A, 
and  thus  the  majority  of  the  board  depose  A  as  president  and 
manager  of  the  concern.  A  opposes  the  action  and  the  case  is 
brought  into  the  court.  B  and  C  being  the  majority  of  the 
board  of  directors,  the  court  upholds  their  action  and  gives  an 
injunction  against  A  not  to  interfere  with  B  and  C. 

B  and  C  then  buy  some  worthless  vacant  property  for  a  few 
dollars,  which  they  appraise  at  an  excessive  value  and  sell  to  the 
company,  taking  stock  in  payment  at  the  increased  values. 
This  stock  is  then  divided  between  B  and  C,  thus  leaving  A  in 
the  minority  as  a  stockholder.  The  factory  then  burns  down 
and  a  low  settlement  is  made  with  the  insurance  companies,  be- 
cause suspicion  was  directed  toward  B  for  having  set  fire  to  the 
property.  Their  assets  having  thus  been  reduced,  and  wishing 
to  make  an  excellent  impression  upon  the  court,  and  further 
wishing  to  hide  their  fraudulent  action  in  placing  the  excessive 
value  on  the  vacant,  valueless  property,  they  decrease  the  capi- 
tal stock  to  about  10  per  cent  of  the  original  capital  stock. 
Each  stockholder  obtains  his  proportionate  share  of  the  new 
stock.  In  this  manner  B  and  C  beat  A  from  a  half  interest  to 
a  sixth  interest. 

They  then  incorporate  a  new  company  called  The  Investment 
Company,  of  which  B  and  C  are  the  only  stockholders  and  in 
which  B  and  C  put  up  $5,000,  which  they  loan  out  on  improved 
realty  to  the  manufacturing  company,  obtaining  therefor  a 
note  secured  by  a  mortgage. 

They  then  proceed  to  incorporate  another  company,  which 
succeeds  the  old  manufacturing  company.  They  value  the  as- 
sets of  the  old  company  at  about  one-third  of  what  they  stand 
on  the  books.  The  new  company  purchases  the  assets  at  the  re- 
duced value,  giving  the  stockholders  of  the  old  company  stock  in 
the  new  concern  in  proportion  of  one  to  three,  thus  reducing  the 
holdings  of  A  from  a  half  to  an  eighth  interest  in  the  same  assets 
of  which  he  was  originally  the  owner.  The  new  company  then 
contracts  with  D,  who  is  another  crook,  to  build  it  a  factory. 
The  contract  made  with  him  is  at  a  figure  which  is  about  $5,000 
higher  than  the  ordinary  contractor  would  have  built  it  for. 


MANIPULATION  BY  DIRECTORS  377 

In  addition  to  this  B  and  C  give  him  a  large  block  of  stock  as  a 
part  consideration  for  the  building  of  the  plant.  This  $5,000 
in  excess  of  the  real  cost  of  the  factory  is  paid  to  D  every  other 
day  in  cash  and  the  books  indicate  that  such  cash  was  for  his 
pay-roll.  But  circumstantial  evidence  points  to  the  fact  that 
these  payments  are  bogus  transactions  on  the  books  and  that  in 
fact  the  money  goes  into  the  bank  account  of  the  Investment 
Company. 

Then  the  Investment  Company  begins  to  play  treasurer  for 
the  new  company,  because  it  has  no  funds.  Thus  it  loans  the 
$5,000  back  to  the  manufacturing  company.  The  new  manu- 
facturing company  needing  more  funds,  the  Investment  Com- 
pany sells  the  $5,000  note  above  mentioned  to  the  manufactur- 
ing company,  permitting  the  manufacturing  company  to  credit 
the  Investment  Company  for  this  $5,000  on  its  books.  The 
manufacturing  company  then  puts  up  the  $5,000  note  as  col- 
lateral for  a  loan  of  $3,000  at  the  Bank.  The  result  is  that 
the  Investment  Company  secures  a  credit  in  its  favor  for  $5,000 
for  an  actual  value  of  but  $3,000.  After  this  transaction  the 
Investment  Company  shows  signs  of  anxiety  for  the  money  it 
has  advanced,  $5,000  in  cash  and  $5,000  in  notes.  It  there- 
fore secures  its  claims  by  a  mortgage  from  the  manufacturing 
company  on  its  new  plant  for  $10,000. 

The  plant  is  completed,  the  stock  bonus  issued  to  the  contrac- 
tor, and  this  stock  transferred  to  the  Investment  Company. 
Circumstantial  evidence  shows  that  no  consideration  was  paid 
by  the  Investment  Company  to  the  contractor  for  this  stock. 
As  the  case  stands  at  present,  the  Investment  Company  is  trying 
to  foreclose  its  mortgage  and  if  successful,  will  entirely  defeat 
the  interest  of  A,  who  in  less  than  eight  months  was  beaten  out 
of  a  more  than  half  interest  in  a  successfully-run  factory. 

I  was  employed  in  this  case  by  order  of  the  court  upon  the 
complaint  of  A  that  B  and  C  were  wasting  the  assets  of  the 
company,  I  cannot  see  how  under  the  laws  of  the  state. A  has 
any  redress  whatever,  except  to  show  fraud  in  the  first  issue  of 
additional  stock  and  in  the  subsequent  decreasing  of  the  capital 


378  CORPORATION  FINANCE 

stock.  But  from  the  point  of  view  of  law  it  will  be  exceedingly 
difficult  to  bring  in  this  evidence.  However,  there  is  a  ray  of 
hope  in  the  horizon;  namely,  that  the  state  statutes  forbid  the 
directors  to  put  a  mortgage  on  a  mining  or  manufacturing 
plant  without  calling  a  special  stockholders'  meeting  and  obtain- 
ing the  consent  of  two-thirds  of  the  stock.  These  directors  had 
two-thirds  of  the  stock  and  could  have  easily  complied  with  the 
requirement,  but  their  attorney  evidently  overlooked  this  point 
and  we  believe  that  we  can  have  this  mortgage  set  aside  and  a 
receiver  appointed.  In  this  case  the  receiver  could  start  suit 
against  B  and  C  and  then  bring  out  these  fraudulent  transac- 
tions. 

The  cases  that  have  been  cited  seem  scarcely  to  call 
for  comment.  They  all — and  especially  the  last  case — 
however,  give  point  to  one  precept,  which  controlling 
stockholders  would  do  well  to  keep  before  them,  namely, 
DO  NOT  PART  WITH  CONTROL.  A  Swindling  or  hostile 
board  of  directors  can  do  more  in  one  session  to  wreck 
a  corporation  and  bring  loss  to  its  honest  stockholders 
than  a  capable  board  can  accomplish  in  years  toward 
repairing  the  damage. 


I 


CHAPTER  XXVII 

MANIPULATION  BY  AND  FOR  STOCKHOLDERS 

218.  Cheating  creditors, — The  subject  matter  of  this 
chapter  is  concerned  with  manipulation  directed 
toward  one  of  two  objects;  either  toward  depriving 
creditors  of  some  of  their  just  rights  for  the  benefit  of 
the  body  of  stockholders;  or  toward  increasing  the 
profits  of  controlling  stockholders  at  the  expense  of 
minority  interests.  In  the  first  case  the  stockholders 
may  be  either  acting  as  a  body,  or  manipulation  carried 
on  primarily  for  the  benefit  of  the  majority  stockholders 
may  be  of  such  a  character  that  the  minority  can  success- 
fully obtain  a  share  in  its  advantages.  Generally 
speaking,  manipulation  by  and  for  stockholders  as  a 
body  is  confined  to  small  close  corporations.  We  shall 
find,  however,  one  or  two  notable  exceptions  to  this  rule. 

We  are  all  of  us  familiar,  some  of  us  perhaps  to  our 
loss,  with  the  old  trick  of  an  individual  or  partnership 
buying  a  stock  of  goods  on  credit,  disposing  of  it 
quickly  and  secretly,  concealing  the  returns  and  shortly 
afterward  going  into  bankruptcy.  The  trick  may  be 
worked  by  corporations  as  well  as  by  partnerships  or  by 
individuals.  Indeed,  the  corporation  affords  an  addi- 
tional advantage  to  the  swindlers  in  that  its  bankruptcy 
need  not  affect  them  in  the  least.  Credit-men  under- 
stand the  game  in  all  its  variations  thoroughly  and  are 
especially  cautious  in  granting  credit  to  small  close  cor- 
porations, no  matter  how  imposing  may  be  their  title 
and  their  capitalization.     This  scheme,  of  course,  is 

379 


380  CORPORATION  FINANCE 

simply  a  plain  case  of  fraud  and  has  no  especial  interest 
for  us  in  this  study. 

A  slightly  different  method  of  reaching  much  the 
same  result  is  to  have  a  corporation  pile  up  a  large  debt 
on  the  strength  of  its  assets  and  then  to  allow  the  assets 
to  depreciate.  Stockholders  of  a  corporation  whose 
outstanding  bonded  debt  is  high  are  always  under 
temptation  to  encourage  this  policy.  By  so  doing  they 
may  secure  large  dividends  for  themselves  over  a  series 
of  years  and  at  the  end  leave  assets  of  small  value  to 
satisfy  the  bondholders.  As  we  have  already  found  in 
our  study  of  corporate  mortgages  (Chapter  IX) 
properly  drawn  instruments  of  this  character  provide 
that  the  property  mortgaged  shall  be  maintained  in  at 
least  as  good  condition  as  at  the  time  that  the  mortgage 
is  drawn,  on  penalty  of  having  the  corporation  put  into 
the  hands  of  receivers.  If  the  trustee  under  the  mort- 
gage performs  his  duties  properly  he  will  see  to  it  that 
this  provision  is  enforced.  If  the  stockholders  and 
directors  acting  for  the  stockholders  really  desire  to 
evade  the  provision,  it  may  require  the  closest  atten- 
tion and  rigorous  action  on  the  part  of  the  trustee  to 
forestall  them. 

219.  The  Chicago  and  Alton  deal. — The  well-known 
instance  of  the  Chicago  and  Alton  Railroad  deal 
illustrates  another  variation  of  the  same  principle.  The 
facts  with  regard  to  the  Chicago  and  Alton  manipula- 
tion which  were  fully  brought  out  in  an  investigation  by 
the  Interstate  Commerce  Commission  in  1907,  may  be 
briefly  summarized  as  follows:  A  close  syndicate  in 
1898  bought  about  80  per  cent  of  the  outstanding  com- 
mon stock  of  the  Chicago  and  Alton  Railroad  Company. 
The  company  had  been  managed  with  great  conserva- 
tism for  several  years  and  had  saved  from  its  earnings 


MANIPULATION  BY  STOCKHOLDERS         381 

and  put  back  into  the  property  a  surplus  of  $12,500,000. 
Now  a  surplus  is  legally,  of  course,  the  property  of  the 
stockholders  of  a  corporation.  It  is  so  unusual,  how- 
ever for  stockholders  to  distribute  this  surplus  directly 
to  themselves  that  bondholders  naturally  look  upon 
it  as  in  part  a  protection  to  themselves  and  buy 
bonds  with  that  understanding.  Ordinarily,  as  has  been 
explained,  the  surplus  is  invested  in  the  form  of  perma- 
nent assets  of  the  corporation,  and  the  value  of  these 
assets  is  a  strong  factor  in  influencing  the  bond  buyer. 
The  syndicate  of  common  stockholders  in  this  case, 
determined  to  secure  for  themselves,  and  incidentally  the 
other  stockholders,  the  accumulated  surplus  of  the  com- 
pany. They  therefore  issued  new  bonds  to  the  extent  of 
$32,000,000,  which  were  sold  at  65  and  the  proceeds, 
about  $21,000,000,  turned  into  the  company's  treasury. 
They  then  declared  an  extra  cash  dividend  of  30  per 
cent  and  thus  transferred  a  large  share  of  the  cash  ob- 
tained by  the  bond  issue  into  their  own  pockets.  The 
action  was  much  discussed  at  the  time,  was  condemned 
by  some  and  defended  by  others,  but  did  not  arouse 
much  public  interest  until  the  investigation  by  the  Inter- 
state Commerce  Commission  in  1907  brought  it  into 
prominence.  Then,  probably  to  the  surprise  of  the 
members  of  the  syndicate,  the  verdict  was  practically 
unanimous  against  them.  They  were  tried  before  the 
bar  of  public  opinion  and  were  found  guilty  of  misuse 
of  corporate  funds  which  had  been  entrusted  to  their 
care.  There  can  be  no  question  but  that  this  unanimity 
on  the  part  of  the  public  is  highly  significant.  It 
means  that  between  1898  and  1907  a  notable  gain  in  the 
public's  knowledge  of  corporation  finance  and  in  the 
public's  conception  of  what  is  and  what  is  not  justifiable 
had  taken  place.     The  gentlemen  who  composed  the 


382  CORPORATION  FINANCE 

syndicate  ought  not  to  be  too  severely  criticised,  for  they 
merely  acted  in  accordance  with  the  custom  of  the 
period.  We  may  well  hope  and  believe  that  manipula- 
tion of  this  kind  and  of  the  other  kinds  that  have  been 
enumerated  will  become  less  and  less  frequent  as  our 
conceptions  of  the  trusteeship  implied  in  almost  all 
corporate  activities  become  clearer. 

220.  Manipulation  through  subsidiary  companies, — 
Another  method  that  is  very  commonly  used  when 
stockholders  plan  to  get  the  better  of  the  creditors  of 
their  corporation,  is  the  device  of  interposing  one  or 
more  corporations  between  the  creditors  and  the  assets 
on  which  they  think  they  have  a  claim.  A  case  in  point 
which  was  recently  settled  out  of  court,  and  in  which 
the  names  of  the  parties  concerned,  therefore,  cannot 
here  be  given,  is  that  of  an  amusement  company  operat- 
ing a  large  park  in  one  of  the  cities  of  the  United  States. 
The  operation  of  the  park  was  extremely  costly  and,  as 
the  price  of  admission  was  only  ten  cents,  the  returns 
were  not  sufficient  to  pay  expenses.  There  were,  how- 
ever, a  large  number  of  shows  and  amusement  enter- 
prises in  the  park  which  were  highly  profitable.  The 
stockholders  of  the  corporation  as  individuals  were 
interested  in  these  sideshows  and  secured  large  profits. 
The  corporation  which  owned  the  park,  on  the  strength 
of  its  apparent  prosperity,  was  able  to  borrow  large 
amounts  of  money.  When  the  time  for  settlement  came 
the  creditors  learned  the  true  state  of  affairs  and  were 
informed  that  their  claims  were  practically  worthless. 
Fortunately  in  this  case  they  were  able  to  bring  such 
pressure  to  bear  on  the  stockholders  that  their  claims 
were  settled.  It  is  quite  evident,  however,  that  as  a 
method  of  getting  loans  and  avoiding  re-payment  the 
scheme  is  workable. 


MANIPULATION  BY  STOCKHOLDERS  383 

Here  is  another  instance  which  shows  that  eminent 
and  entirely  respectable  railroad  directors  are  not  above 
working  the  same  trick  for  the  benefit  of  their  road. 
The  N.  E.  Railway  owned  a  majority  of  the  stock  of 
a  small  rail  and  boat  line  which  had  income  bonds 
outstanding.  The  large  company,  being  in  control, 
was  able  to  apportion  traffic  and  earnings  as  it  pleased 
and  gave  less  than  its  share  to  the  small  line.  Three  of 
the  boats  owned  by  the  small  company  were  being  paid 
for  on  the  installment  plan  and  one  of  these  payments 
was  allowed  to  lapse,  thereby  forfeiting  the  interest  of 
the  small  company  in  the  boats.  The  large  railroad 
company  then  bought  the  boats  from  the  vendors,  being 
allowed  the  amount  which  had  already  been  paid  by  the 
small  company.  Then  a  consolidation  of  the  large  and 
the  small  companies  was  determined  upon  and,  as  the 
earnings  of  the  small  company  had  been  practically 
stopped,  its  shareholders  received  only  one  share  in  the 
new  consolidated  company  for  every  ten  shares  in  their 
possession.  The  income  bondholders  received  no  interest 
after  the  large  company  came  into  control  and  when 
the  consolidation  took  place  were  compelled  to  consent 
to  a  great  reduction  of  their  claims.  The  case  was 
threshed  out  in  the  courts  and  it  was  decided  that  all  the 
steps  taken  were  legal,  except  the  voluntary  passing  of 
the  payment  on  the  boats. 

221.  Central  of  Georgia  income  account, — Another 
case  in  point,  that  at  the  time  of  writing  this  book  is 
attracting  attention  in  the  financial  world,  is  set  forth 
in  the  suit  of  the  income  bondholders  of  the  Central 
of  Georgia  Railroad  Company  for  the  payment  of 
interest  in  full  on  the  bonds.  The  reader  will  recall  that 
in  describing  the  nature  of  income  bonds  it  was  stated 
that  they  are  falling  into  disuse  on  account  of  the  in- 


384  CORPORATION  FINANCE 

evitable  disputes  that  arise  as  to  what  are  and  what  are 
not  profits.  The  bonds  in  question  were  issued  in  1895 
at  the  time  of  the  reorganization  of  the  old  Central 
Railroad  and  Banking  Company  of  Georgia. 

This  case  well  illustrates  the  subject  now  under  dis- 
cussion, inasmuch  as  it  discloses  one  method  of  manipula- 
tion in  favor  of  stockholders  at-  the  expense  of  creditors. 
The  principal  fact  alleged  by  counsel  for  the  income 
bondholders,  and  practically  admitted  by  the  railway 
company,  is  that  a  subsidiary  corporation,  the  Ocean 
Steamship  Company,  almost  all  of  the  stock  of  which  is 
owned  by  the  Central  of  Georgia  Railway  Company, 
has  been  making  large  profits  and  that  these  profits 
have  been  appropriated  by  the  railway  company.  Evi- 
dence disclosed  that  the  Ocean  Steamship  Company 
kept  no  separate  bank  account  but  deposited  all  its  funds 
to  the  credit  of  the  Central  of  Georgia  Railway  Com- 
pany. There  were,  however,  separate  books  of  account 
for  the  two  companies  and  it  was  claimed  at  the  suit, 
on  behalf  of  the  railway  company,  that  the  earnings  of 
the  steamship  company  were  simply  loaned  to  the  parent 
corporation.  These  earnings,  the  reader  should  under- 
stand, were  not  used  in  order  to  declare  dividends  on  thcj 
stock  of  the  Ocean  Steamship  Company  held  in  th( 
treasury  of  the  railway  company,  but  were  turned  ovei 
bodily  under  the  fiction  of  a  "loan";  therefore  the 
earnings  of  the  steamship  company  did  not  appear  at  all 
in  the  income  account  of  the  railway  company,  and  the 
railway  company  thereby  avoided  showing  sufficient 
profits  to  pay  interest  to  the  income  bondholders.  The 
counsel  for  the  railway  company  urged,  according  to  the 
brief  of  petitioners'  counsel,  "that  the  net  earnings  of 
the  steamship  company  should  not  be  included  in  the 
income  account  of  the  railway  company  and  that  unless 


MANIPULATION  BY  STOCKHOLDERS         385 

a  dividend  is  declared  by  the  steamship  company  no  part 
of  the  net  earnings  of  the  steamship  company  belong 
to  the  railway  company  or  are  pledged  to  the  bond- 
holders, and  that  the  question  of  declaration  of  a 
dividend  is  a  matter  of  discretion  lodged  with  the  board 
of  directors  of  the  steamship  company,  with  which  a 
court  of  equity  should  not  interfere.  In  other  words, 
the  railway  company  interposes  the  doctrine  of  *corpo- 
rate  entity'  and  desires  to  have  what  it  regards  as  the 
*sacredness'  of  the  doctrine  taken  cognizance  of  by  a 
court  of  equity." 

At  the  date  of  writing  no  decision  has  been  given  by 
the  court  and  no  one  can  say  exactly  what  the  law  on  the 
subject  is.  It  seems  clear,  however,  to  a  layman  that 
the  subsidiary  corporation  is  here  used  as  a  device  to 
prevent  the  income  bondholders  from  securing  profits 
that  have  actually  been  earned. 

These  cases  are  sufficient  to  show  what  risks  creditors 
may  unwittingly  take  on  themselves  and  how  careful 
they  should  be  in  fixing  the  terms  of  their  mortgage. 
Especially  is  this  true  in  dealing  with  corporations  which 
carry  on  several  activities  and  which  may  through 
separate  companies  readily  divert  their  earnings  from 
[the  rightful  creditors  to  the  stockholders. 

222.  Squeezing  the  minority  stockholders, — We  are 
[ready  now  to  take  up  the  second  group  of  manipulative 
methods  to  be  discussed  in  this  chapter,  namely  those 
methods  which  are  designed  to  enrich  controlling  stock- 
holders at  the  expense  of  minority  interests.  Let  us 
consider  first  the  following  instance,  taken  from  a 
Missouri  court  decision,  of  willful  mismanagement : 

The  Olympic  Theatre  Company  was  organized  in 
May,  1903,  with  a  capitalization  of  $50,000.  E.  S. 
James,  Sr.,  obtained  240  shares,  par  value  $100,  and 

1—35 


386  CORPORATION  FINANCE 

J.  S.  Mcintosh,  150  shares;  the  other  110  shares  were 
never  issued.  Three  days  after  the  organization  the 
company  obtained  a  hundred-year  lease  of  a  lot  in  St. 
Louis.  Under  the  terms  of  the  lease  the  company  was 
to  pay  the  owner  a  rent  of  $2,500  for  the  first  two  years 
and  thereafter  at  the  rate  of  6  per  cent  of  the  appraised 
value  of  the  lot.  The  company  had  the  right  to  pur- 
chase at  the  appraised  value  at  the  end  of  five  years. 
The  lease  was  to  become  void  by  non-performance  of 
any  of  its  conditions  and,  in  the  event  of  its  being 
voided,  the  owners  of  the  lot  were  to  get  full  title  to 
whatever  buildings  the  theatre  company  might  erect  on 
the  lot.  The  company  erected  a  building  and  conducted 
a  theatre. 

In  1905  Mcintosh  sold  his  stock  to  Robert  Henry, 
and  Henry  became  a  director  and  treasurer  of  the 
company.  E.  S.  James  gave  ten  shares  of  stock  to  his 
son,  E.  S.  James,  Jr.,  and  made  him  the  third  director. 
In  1907  James,  Sr.,  transferred  ten  shares  to  another 
son,  Alfred  James,  and  ten  shares  to  a  clerk,  L.  R. 
Osgood.  In  the  same  year  the  new  board  of  directors 
elected  were  James,  Sr.,  James,  Jr.,  and  Osgood,  thus 
forcing  Henry  out.  In  1908,  as  the  company  was  not 
strong  enough  financially  to  buy  the  lot,  the  stockholders 
gave  the  directors  the  right  to  dispose  of  the  company's 
option  to  any  stockholder.  The  directors  immediately 
sold  the  option  for  $50  to  James,  Sr.,  who  there- 
upon resigned  as  president  and  director  and  had  his 
son  Alfred  elected  in  his  place.  James,  Sr.,  then  used 
his  option  to  buy  the  lot  for  $50,000  and  made  an  agree- 
ment with  the  company  fixing  its  appraised  value  at 
$65,000  and  its  annual  rental  at  $3,500.  Alfred  James 
then  resigned  his  offices  and  his  father  was  re-elected 
president  and  director.     The  board  failed  to  pay  the 


MANIPULATION  BY  STOCKHOLDERS         387 

rent  when  due  and  James,  Sr.,  as  owner  of  the  lot  under 
the  terms  of  the  lease  to  the  company,  declared  the  lease 
void  and  was  placed  in  possession  of  the  lot  and  the 
building  erected  thereon.  Henry,  the  minority  stock- 
holder, brought  suit  and  it  was  finally  decided  that  suffi- 
cient evidence  of  fraud  had  been  produced  to  warrant  the 
court  in  reinstating  the  lessee  in  possession  of  the  theatre 
under  the  terms  of  the  lease. 

It  may  be  inferred  from  the  decision  that  two  factors 
which  decided  the  court  in  favor  of  the  plaintiff  were 
first,  that  the  James  family  were  evidently  acting  as  a 
unit,  and,  second,  that  the  books  of  the  corporation  had 
been  destroyed.  These  were  tactical  errors  which  might 
readily  have  been  avoided ;  if  they  had  not  been  present, 
it  is  safe  to  say  that  the  whole  series  of  transactions 
would  have  been  found  legal. 

A  more  simple  and  common  case  is  stated  in  a  recent 
decision  of  one  of  the  federal  circuit  courts.  The  officers 
and  owners  of  a  majority  of  the  stock  of  a  wire  company 
voted  as  stockholders  to  lease  the  property  of  the  com- 
pany at  a  low  rental  to  another  corporation,  all  of  whose 
stock  was  held  by  these  same  majority  stockholders.  INTo 
fraud  was  shown  and  the  petition  of  the  minority  stock- 
holders to  set  aside  the  lease  was  not  granted. 

In  another  federal  court  case  it  was  shown  that  the 
majority  stockholder  of  a  gas  company  absolutely 
dominated  the  board  of  directors  and  induced  the  board 
to  purchase  worthless  bonds  of  another  corporation  in 
which  he  was  interested,  by  which  he  was  able  to  make 
a  large  individual  profit.  Here  again  the  minority 
stockholders,  in  spite  of  their  unremitting  efforts,  were 
unable  to  prove  fraud. 

223.  A  complicated  real  estate  proposition, — Here 
is  an  instance  furnished  by  a  prominent  accountant 


388  CORPORATION  FINANCE 

and  which  is  stated  to  be  typical  of  the  operations 
of  a  certain  group  of  companies.  The  Suburban 
Development  Company  is  a  close  corporation  which 
speculates  in  acreage  and  sells  city  lots  on  a  commission 
basis.  The  company  sells  a  piece  of  property  belonging 
to  an  outsider.  Smith,  to  the  Redbank  Realty  Company. 
This  last  named  company  is  in  reality  a  subsidiary 
corporation,  all  of  whose  stock  is  owned  by  the  Suburban 
Development  Company.  The  Suburban  Development 
Company  collects  a  commission  from  Smith  for  selling 
his  property. 

The  company  now  organizes  a  third  corporation,  the 
Long  View  Land  Company,  which  buys  the  property 
at  a  handsome  advance  and  assumes  the  mortgage 
which  was  on  the  property  when  Smith  owned  it.  The 
Long  View  Land  Company,  in  addition  to  assuming 
the  mortgage,  issues  all  its  stock  to  the  Suburban 
Development  Company  for  the  balance  of  its  purchase 
price.  The  Long  View  Land  Company  now  makes  a 
contract  with  the  Suburban  Development  Company 
whereby  the  last-named  corporation  sells  the  lots  on  a 
commission  of  20  per  cent.  The  Long  View  Land 
Company  is  also  charged  an  exorbitant  amount  for 
office  rent  and  pays  large  salaries  to  its  officers,  who  are_ 
the  stockholders  in  the  Suburban  Development  Coi 
pany. 

The  Suburban  Development  Company  now  pushei 
the  sales  of  the  lots  owned  by  the  Long  View  Land  Com- 
pany. When  no  outsiders  can  be  induced  to  buy,  other 
subsidiary  corporations  are  formed  which  buy  lots  at 
high  prices  from  the  Long  View  Land  Company. 
Thus  this  company  is  given  a  fictitious  appearance  of 
great  prosperity  and  a  surplus  is  created  on  the  books. 
With  such  a  showing  it  is  easy  to  find  purchasers  of  the 


MANIPULATION  BY  STOCKHOLDERS         389 

stock  of  the  Long  View  Land  Company,  which  is  in  the 
treasury  of  the  Suburban  Development  Company. 
After  all  but  the  controlling  shares  are  sold,  the  sub- 
sidiary companies  which  have  bought  lots  from  the  Long 
View  Land  Company  go  into  bankruptcy,  the  lots  are 
returned  and  the  paper  profits  of  the  Long  View  Land 
Company  suddenly  vanish  into  thin  air. 

The  object  of  this  complicated  series  of  transactions, 
as  the  reader  will  see,  is  simply  to  sell  the  minority  stock 
of  the  Long  View  Land  Company.  The  majority 
shares  must  be  retained  in  the  hands  of  the  manipulators 
in  order  to  avoid  investigation  and  litigation.  The  com- 
pany advertised  and  kept  before  the  public  in  all  these 
transactions  is,  of  course,  the  Long  View  Land  Com- 
pany. All  the  time,  however,  the  stockholders  of  the 
controlling  corporation  are  calmly  pocketing  all  the 
real  profits. 

The  above  illustrations  are  typical.  It  would  seem 
impossible  to  enumerate  all  the  possible  variations  in 
method.  The  feature  common  to  them  all,  however,  is 
the  transfer  of  property  from  one  corporation  to  another 
corporation  owned  by  the  majority  stockholders  of  cor- 
poration number  one.  This  is  what  the  minority  stock- 
holder must  always  fear  and,  so  far  as  possible,  provide 
against.  There  is  no  other  way  of  preventing  such 
manipulation  except  by  associating  only  with  honest 
majority  stockholders  in  companies  where  the  fullest 
publicity  obtains. 

224.  Robbing  a  partnership  to  pay  a  corporation, — 
One  more  instance  should  be  added  to  the  list  already 
given,  for  it  shows  very  clearly  what  may  be  accom- 
plished in  the  way  of  defrauding  helpless  and  ignorant 
minority  owners. 

James  Ehrenbahn,  a  partner  in  the  firm  of  L.  A. 


390  CORPORATION  FINANCE 

Ehrenbahn  and  Company,  manufacturers  of  agricul- 
tural implements,  died  in  the  year  1896.  He  had  an 
undivided  one-fourth  interest  in  the  firm  and  in  addi- 
tion had  loaned  the  firm  $3,000.  He  also  had  a 
one-third  interest  in  a  credit  against  the  firm  of  $12,000, 
the  other  two-thirds  belonging  to  his  brother,  L.  A. 
Ehrenbahn.  The  firm  held  property  whose  book  value 
was  approximately  $260,000.  Immediately  after  the 
death  of  James  Ehrenbahn  the  surviving  partners 
caused  to  be  written  o&  to  profit  and  loss  accounts  and 
bills  receivable  alleged  to  be  uncollectible  amounting  to 
$110,000,  leaving  a  net  book  value  of  the  property  of 
the  firm  of  approximately  $150,000.  L.  A.  Ehrenbahn 
was  acting  not  only  for  himself  but  also  for  the  estate 
of  his  brother,  of  which  he  had  been  appointed  adminis- 
trator. The  surviving  partners  made  no  attempt  to 
close  the  affairs  of  the  firm,  but  continued  in  business 
and  made  large  profits,  of  which  they  rendered  no  ac- 
counting. In  continuing  the  business  they  used  up 
money  and  property  belonging  to  the  estate  of  James 
Ehrenbahn. 

About  October  1, 1898,  the  surviving  partners  agreed 
to  form  a  corporation,  lease  to  it  the  plant  and  real 
estate  of  the  co-partnership  and  sell  to  it  on  credit,  the 
terms  being  indefinite,  the  personal  property,  accounts 
and  bills  receivable  in  the  hands  of  the  surviving 
partners.  The  corporation  took  over  the  inventory  of 
finished  products  at  an  appraised  value  to  be  paid  for 
out  of  money  received  from  the  sale  of  implements  on 
hand.  The  organization  of  the  cori)oration  was  in  1898 
and  its  operations  began  the  same  year,  but  no  stock  was 
issued  until  1903. 

A  peculiarity  of  the  business  thus  transferred  was 
that  large  amounts  of  agricultural  instruments  were 


MANIPULATION  BY  STOCKHOLDERS         391 

sold  "on  consignment"  to  agents  who  had  the  privilege 
of  either  returning  the  goods  or  of  paying  for  them. 
The  corporation  now  began  to  deal  with  these  agents, 
sent  them  new  stocks  of  goods  and  allowed  them  without 
protest  to  return  the  goods  which  had  been  sent  them 
on  consignment  by  the  partnership;  thus  the  accounts 
and  bills  receivable  of  the  partnership  were  rendered 
worthless  and  their  place  was  taken  by  accounts  re- 
ceivable of  the  corporation.  Furthermore,  the  corpora- 
tion used  no  diligence  in  collecting  the  accounts  re- 
ceivable of  the  partnership  that  were  left  outstanding. 

In  March,  1903,  L.  A.  Ehrenbahn  for  himself,  and 
assuming  to  act  as  administrator  of  his  brother's  estate, 
delivered  a  new  lease  to  the  corporation  of  the  land  and 
buildings  belonging  to  the  partnership  at  the  excessively 
low  rate  of  $1,000  a  year.  In  the  same  year  the  partner- 
ship made  a  final  sale  to  the  corporation  of  the  personal 
property  for  $20,000,  although  this  same  property  had 
been  valued  in  1898  at  $50,000.  Between  1898  and 
1903  the  corporation  paid  nothing  for  the  property  or 
for  its  use.  Beginning  in  1904  the  corporation  paid 
annual  10  per  cent  dividends  on  a  capitalization  of 
$100,000.  The  record  does  not  show  what  dividends 
were  paid  between  1898  and  1904.  When  the  case 
came  into  court  on  complaint  of  the  heirs  of  James 
Ehrenbahn  decision  in  substance  was  that  the  corpora- 
tion should  be  compelled  to  pay  a  price  to  be  fixed  after 
investigation  by  a  master  for  the  personal  property  and 
real  estate.  It  was  adjudged,  however,  in  the  case  of 
accounts  and  bills  receivable,  that  no  legal  liability  lay 
against  the  corporation. 

There  can  be  no  question,  judging  from  the  facts 
as  presented  to  the  court,  that  large  sums  had  been  de- 
liberately withheld  from  the  partnership  and  transferred 


392  CORPORATION  FINANCE 

to  the  corporation  by  the  manipulation  of  the  accounts 
and  bills  receivable.  Yet  this  manipulation  could  be 
carried  on  so  easily  by  the  corporation  that  it  was  im- 
possible to  prove  fraud  or  bad  faith. 

225.  Remedies  for  manipulation, — The  examples  that 
have  been  cited  in  these  three  chapters  on  corporate 
manipulation  seem  to  the  writer  not  only  interesting 
but  highly  instructive.  It  is  an  unpleasant  duty  to 
record  instance  after  instance  of  cunning  rascality, 
especially  when  the  record  to  be  truthful  must  set  forth 
at  least  temporary  successes  on  the  part  of  the  rascals. 
As  was  said  at  the  beginning,  the  swindling  operations 
are  for  the  most  part  in  a  field  which  the  law  does  not 
reach  and  their  perpetrators  are  seldom  given  the  legal 
punishment  to  which  they  are  justly  entitled.  For- 
tunately the  punishment  of  social  opprobrium  and  loss 
of  business  standing  is  generally  visited  upon  them. 

The  purpose  of  these  chapters  will  have  been  secured 
if  they  serve  to  warn  owners  of  corporate  securities  of 
the  facilities  which  the  corporate  form  affords  for  graft 
and  dishonesty.  The  writer  desires  to  reiterate  that 
instances  of  the  kind  that  have  been  narrated  are  rare 
compared  to  the  vast  amount  of  entirely  honorable  andj 
legitimate  business  transacted  under  the  corporate  form 
of  business  organization.  Nevertheless  they  are  fre- 
quent enough  to  demand  attention  and,  so  far  as  pos- 
sible, prevention. 

One  preventive  is  for  security-holders  to  insist  on 
complete  and  absolute  publicity  as  to  the  affairs  of  their  ^ 
organizations. 

Another  preventive  is  for  them  to  attend  stockholders*^ 
meetings  and  take  an  active  interest  in  all  that  goes  on 
in  the  corporation. 

A  third  preventive  is  to  see  to  it  that  under  the  cumu- 


MANIPULATION  BY  STOCKHOLDERS 

lative  system  of  voting  every  stockholder  gets  a  chance 
to  be  represented. 

A  fourth  preventive  is  to  insert  expHcit  provisions 
in  the  corporate  by-laws  as  to  salaries  of  officers,  amount 
of  indebtedness  to  be  incurred,  amount  of  surplus  to  be 
set  aside  each  year,  and  so  on. 

The  best  preventive  of  all,  however — ^without  which 
all  the  other  measures  will  prove  of  small  avail — is  for 
the  security-holder  to  investigate  with  the  greatest  care 
the  reputations  of  all  the  officers  and  directors  of  the 
corporation. 


> 


CHAPTER  XXVIII 

INSOLVENCY  AND  RECEIVERSHIPS 

226.  Two  types  of  insolvency, — The  causes  of  in- 
solvency have  perhaps  been  sufficiently  indicated  in 
connection  with  the  subject  of  management  of  capital 
funds  and  of  earnings.  At  any  rate,  they  may  be 
inferred  to  be  the  reverse  of  the  principles  of  sound 
corporate  finance,  which  were  there  laid  down.  It  will 
do  no  harm,  however,  to  recapitulate  briefly  the  principal 
causes.  A  great  many  business  men,  even  the  managers 
of  large  corporations,  are  evidently  not  fully  alive  to 
the  dangers  which  threaten  any  corporation. 

It  is  well  to  distinguish  between  two  types  of  in- 
solvency. The  distinction  for  our  purpose  is  important, 
although  in  law  and  in  ordinary  business  language  it  has 
not  been  clearly  kept  in  view.  We  may  call  one  type 
"true"  and  the  other  "legal"  insolvency.  True  insol- 
vency exists  where  the  value  of  an  individual's,  firm's  or 
corporation's  assets  is  less  than  its  total  debts.  This, 
by  the  way,  is  substantially  the  definition  given  in 
the  National  Bankruptcy  Act,  but  it  is  declared  by] 
eminent  legal  authorities  to  be  a  definition  without 
precedent  in  the  law.  Such  insolvency  may  or  may  not 
lead  to  failure.  Certainly  if  failure  is  not  to  follow 
there  must  be  an  improvement  in  the  condition  of  the 
business.  It  frequently  happens,  however,  where  debts 
are  not  immediately  payable,  that  a  concern  insolvent 
in  this  sense  will  manage  to  pull  out  of  its  difficulties 
and  meet  its  obligations  when  they  filially  mature. 

394 


INSOLVENCY  AND  RECEIVERSHIPS  395 

Legal  insolvency  exists  when  a  concern's  cash  assets 
are  insufficient  to  meet  its  liabilities  as  they  fall  due.  It 
may  well  be,  and  frequently  is,  true  in  such  a  case  that 
the  total  assets  would  far  overbalance  the  total  obliga- 
tions. As  obligations  are  almost  uniformly  payable  in 
cash  and  cash  only,  however,  it  really  makes  no  differ- 
ence how  great  the  value  of  the  firm's  unsalable  assets 
may  be.  Legal  insolvency  almost  of  necessity  leads 
immediately  to  suspension  or,  in  the  case  of  small 
concerns,  to  bankruptcy.  The  only  escape  would  be 
a  compromise  of  some  kind  accepted  by  creditors. 

227.  Causes  of  true  insolvency, — True  insolvency 
may  exist  from  the  very  beginning  of  corporate 
existence,  although  not  usually  without  bad  faith  on  the 
part  of  the  incorporators.  It  is  possible,  however,  that 
the  value  of  a  corporation's  assets  at  the  beginning  may 
be  honestly  over-estimated,  that  the  corporation  may 
borrow  an  undue  amount  of  money  secured  by  such 
assets,  and  that  the  money  thus  obtained  may  be  fool- 
ishly expended.  In  such  a  case,  unless  a  marked  rise 
in  the  value  of  the  assets  takes  place,  the  corporation 
may  be  said  never  to  have  been  truly  solvent.  It  is  only 
a  question  of  time  until  the  inevitable  failure  arrives. 

A  second  cause  of  true  insolvency  may  be  a  great  and 
perhaps  unavoidable  decline  in  the  value  of  a  corpora- 
tion's assets.  If,  for  instance,  a  cyclone  demolishes  the 
property  of  a  corporation  that  does  not  carry  insurance 
against  such  a  calamity,  insolvency  will  necessarily  be 
the  result.  The  fall  in  the  value  of  the  assets  may  be 
due  simply  to  ordinary  causes,  which  are  not  offset  by  a 
depreciation  reserve.  Any  one  of  a  hundred  other 
events,  which  will  occur  to  every  reader,  may  reduce  the 
value  of  assets  below  obligations.  It  may  be  stated, 
however,  that  a  conservatively  managed  corporation  is 


396  CORPORATION  FINANCE 

not  likely  to  suffer  in  this  way.  The  principles  of  in- 
surance and  of  depreciation  are  now  so  widely  applied 
that  a  high  degree  of  protection  is  afforded. 

The  third  cause  of  true  insolvency,  especially  with 
trading  companies,  is  bad  management  in  buying  and 
selling  goods.  The  lack  of  a  proper  system  of  cost  ac- 
counting may  lead  corporation  managers  to  a  long- 
continued  course  of  selling  below  cost.  The  fact  that 
such  a  course  has  been  followed  may  not  become  entirely 
apparent  for  a  number  of  years;  then  it  is  found  that 
the  corporation  has  been  gradually  consuming  its  capi- 
tal funds  in  order  to  pay  running  expenses. 

The  complexity  of  modern  business  is  such  that  fre- 
quently an  accurate  and  searching  analysis  carried  on 
at  considerable  expense  is  necessary  in  order  to  deter- 
mine whether  a  business  is  being  carried  on  at  a  profit 
or  not.  Many  a  concern  has  seen  its  sales  growing, 
its  gross  profits  swelling  and  apparently  its  surplus 
increasing,  while  at  the  same  time,  owing  to  lack  of  care 
to  maintain  its  fixed  assets  in  good  condition  and  to  keep, 
up  its  established  trade,  it  has  in  reahty  been  moving! 
rapidly  into  insolvency.  An  anecdote  is  told  of  a  large 
wholesale  dealer  in  men's  clothing  who  was  selling 
quantities  of  goods  at  prices  which  expert  accountants 
found  to  be  considerably  below  cost,  including  in  cost^ 
all  the  selling  and  administrative  expenses.  The  ac- 
countant approached  the  manager  of  the  company  and 
asked  him  how  he  could  afford  to  carry  on  his  business. 
"Ah,"  was  the  naive  reply,  "you  see  our  transactions 
are  on  so  much  larger  a  scale  than  those  of  any  of  our 
competitors."  It  seems  needless  to  add  that  this  par- 
ticular concern  did  not  long  keep  out  of  the  bankruptcy 
court. 

The  fourth  cause  of  true  insolvency  is  actual  fraud 


INSOLVENCY  AND  RECEIVERSHIPS 


397 


or  theft,  a  cause  which  need  not  be  here  discussed. 
228.  One  cause  of  legal  insolvency — ''lack  of  capital/' 
— As  to  the  causes  of  legal  insolvency,  we  have  a  val- 
uable mass  of  information  collected  by  the  two  great 
mercantile  agencies,  Bradstreet's  and  Dun's.  The 
Bradstreet  Company  summarize  their  judgments  as 
to  the  prime  causes  of  all  the  business  failures  that  oc- 
curred in  the  United  States  in  the  years  1904-1907,  in 
the  following  table: 


Causes  of  Failure. 


Incompetence    

Inexperience    

Lack  of  capital... 
Unwise  credits  . . . 
Failures  of  others 

Extravagance 

Neglect  

Competition 

Specific  conditions 

Speculation    

Fraud   


Percentages. 


1907 


4.9 

37.1 

8.3 

1.4 

.9 

f.5 

IS 

16.3 

.7 

10.1 


1906 


22.3 
4.9 

35.9 
2.6 
2.0 
1.0 
2.2 
1.0 

17.3 
.8 

10.0 


1905 


24.4 
4.8 

33.4 
3.5 
2.2 
1.1 
2.9 
1.5 

16.3 

.7 

9.2 


1904 


23.1 
5.1 

32.2 
3.4 
2.5 
.8 
3.1 
1.3 

19.1 

.8 

8.6 


The  reader  will  notice  that  "lack  of  capital"  heads  the 
list  and  that  personal  incompetence  comes  second.  Un- 
fortunately no  distinction  is  made  between  lack  of  per- 
manent capital  and  lack  of  working  capital.  It  seems 
safe  to  say,  however,  that  lack  of  permanent  capital  does 
not  usually  in  itself  lead  to  insolvency;  most  businesses 
may  be  automatically  adjusted  to  any  reasonable  amount 
of  capital.  The  difficulty  comes  rather  in  the  form  in 
which  the  capital  funds  are  invested,  particularly  in 
sacrificing  quick  in  order  to  build  up  fixed  assets. 

To  make  this  statement  concrete  let  us  examine  the 
Wall  Street  Journal's  analysis  of  two  recent  instances 
of  financial  difficulty.  In  February,  1909,  the  Ameri- 
can Ice  Company  was  reported  to  be  facing  insolvency 


398 


CORPORATION  FINANCE 


and  reorganization  and  the  Journal  commented  as  fol- 
lows: 

The  annual  report  just  submitted  shows  that  the  floating 
debt,  about  $650,000  a  year  ago,  has  now  reached  the  threaten- 
ing proportions  of  something  hke  $1,250,000.  Herein  lies  the 
whole  trouble  with  the  American  Ice  Company.  The  concern 
transacted  a  gross  business  during  the  year  ended  October  31, 
of  $8,120,000,  and  it  is  clear  that  to  maintain  this  volume  of 
business  ample  liquid  capital  is  essential.  The  report  evidences 
the  need  of  working  funds  in  other  ways;  it  shows  that  $72,- 
728  was  expended  for  interest  on  its  floating  debt. 

Where  the  company  will  raise  money  is  a  problem.  It  is 
known  that  institutions  friendly  to  the  company  which  have 
helped  it  out  of  difficulties  in  the  past,  have  withdrawn  further 
support.  The  company  has  little  credit  of  its  own  to  borrow 
on.  The  treasury  contains  several  hundred  thousand  dollars 
worth,  par  value,  of  securities  of  subsidiary  concerns,  but  these 
are  hardly  sufficient  for  collateral  for  a  loan  as  large  as  Amer- 
ican Ice  requires. 

Evidently  the  company  was  in  danger  of  legal,  not 
true,  insolvency.  Since  the  above  paragraphs  were 
written  the  ice  company  has  denied  its  allegations  and 
states  that  it  is  not  in  serious  need  of  financial  assistance. 
Nevertheless  the  quotation  indicates  clearly  enough; 
where  a  trained  financial  writer  looks  for  symptoms  and 
causes  of  weakness. 

229.  The  case  of  the  Detroit,  Toledo  and  Ironton 
Railway  Company, — The  paragraphs  that  follow  con- 
stitute an  attempt  to  explain  the  failure  of  the  Detroit, 
Toledo  and  Ironton  Railway  Company. 

The  company  in  question,  a  reorganization  of  the  old  Detroit 
Southern,  began  business  in  the  early  part  of  1905.  When  the 
management  of  the  property  again  passed  into  the  hands  of 
the  court  this  year,  its  new  career  had  lasted  about  two  and  a^ 


I 

I 


INSOLVENCY  AND  RECEIVERSHIPS  399 

half  years,  during  no  part  of  which  had  it  succeeded  in  earning 
the  fixed  charges  which  the  capitalization  of  the  reorganization 
plan  had  fastened  upon  it.  In  the  first  full  fiscal  year  of  its 
operation  as  an  extended  system,  the  deficit  after  payment  of 
interest  charges  and  taxes  amounted  to  $270,000 ;  in  the  second 
^  fiscal  year  which  ended  June  30th  last,  the  deficit  reached  the 
sum  of  $371,000.  After  that,  presumably,  the  company  ran 
still  further  behind. 

As  to  the  question  of  working  capital,  the  Detroit,  Toledo 
&  Ironton's  balance  sheet  of  June  30,  1905,  practically  the  be- 
ginning of  its  career,  shows  current  assets  of  $1,218,524  and 
current  liabilities  of  $390,194,  making  an  apparent  working 
balance  of  $828,330.  Among  these  current  assets  was  an  item, 
"  due  from  reorganization  committee,  $1,050,000."  A  year 
later  this  item  had  disappeared  into  equipment  account,  and  the 
inference  is  that  it  never  was  a  part  of  true  working  capital.  In 
that  case,  the  new  company  began  without  any  working  cap- 
ital, but  with  an  actual  funded  debt  of  about  $200,000. 

If  President  Zimmerman's  theory  that  the  receivership  is  pri- 
marily attributable  to  the  clause  of  the  Hepburn  law  which  for- 
bade the  company  to  proceed  with  its  Kentucky  coal  mining 
project  is  true,  the  Detroit,  Toledo  &  Ironton  as  it  exists  was 
not  a  success  to  begin  with.  That  is,  it  did  not  have  and  could 
not  obtain  a  current  revenue  sufficient  to  carry  its  own  obliga- 
tions, aside  from  the  cost  of  the  Ohio  River  Bridge  and  Ken- 
tucky extension,  and  could  only  become  a  self-sustaining  prop- 
erty by  tapping  an  entirely  new  and  rather  distant  source  of 
traffic.  Such  a  development  naturally  could  not  take  place 
except  through  the  investment  of  much  additional  capital  and 
the  completion  of  works  bound  to  take  a  year  or  two  in  con- 
struction. Meanwhile  the  company  was  exposed  in  a  perilous 
financial  condition  to  the  usual  danger  of  adverse  general  con- 
ditions, which  did  not  fail  to  arrive. 

The  two  causes  assigned  in  this  ease  are:  Firsts  lack 
of  earning  power  in  the  assets  sufficient  to  meet 
fixed  charges,  which  is  a  condition  of  true  insolvency; 


400  CORPORATION  FINANCE 

and,  second,  lack  of  current  assets,  or  of  working 
capital. 

230.  Additional  causes  of  legal  insolvency, — ^We 
have  found  in  our  study  of  financial  management  that 
it  is  not  usually  advisable  for  a  concern  to  allow  its  ac- 
counts payable  to  exceed  70  to  80  per  cent  of  its  ac- 
counts receivable;  that  its  bank  loans  should  be  repre- 
sented for  the  most  part  by  cash  in  the  bank;  and  that 
its  finished  products  on  hand  should  not  be  offset  by  any 
corresponding  liability.  If  these  relations  are  not  main- 
tained, the  company  is  apt  to  sink  first  into  an  unprof- 
itable and  next  into  a  highly  dangerous  situation.  The 
concern  begins  to  lose  profits,  if  its  working  capital  is 
insufficient  to  permit  taking  full  advantage  of  all  con- 
siderable discounts  for  the  prompt  payment  of  bills. 
This  point  has  already  been  discussed  in  connection  with 
financial  management.  It  is  obvious  that  as  working 
capital  decreases  the  corporation  manager  is  driven  to 
depend  more  and  more  upon  his  current  sales  and  ac- 
counts receivable  for  funds  with  which  to  pay  his  bills. 
If  for  any  reason  his  sales  fall  off  sharply  or  his  debtors 
fail  to  pay  promptly,  he  will  be  unable  to  meet  his  own 
obligations  promptly.  Unless  he  can  secure  extensions 
or  arrange  for  loans  from  some  other  source  failure  is 
inevitable. 

Let  us  give  attention  again — for  this  is  an  important 
point — to  the  fact  that  a  concern  may  fail  in  this  manner 
although  its  assets  may  be  thoroughly  sound  and  far  in 
excess  of  obligations,  its  business  large  and  growing, 
and  its  profits  great.  Carelessness  or  lack  of  apprecia- 
tion of  the  necessity  of  keeping  up  working  capital  may 
thus  be  the  sole  cause  of  legal  insolvency.  As  to  the 
statement  that  the  trouble  with  many  concerns  is  "lack 
of  capital,"  our  analysis  has  indicated  that  the  proper 


INSOLVENCY  AND  RECEIVERSHIPS  401 

wording  of  this  phrase  in  most  cases  would  be  "lack  of 
working  capital." 

A  slightly  different  cause  of  legal  insolvency  arises 
when  a  corporation,  in  order  to  pay  dividends,  unduly 
increases  its  quick  obligations.  It  may  well  be  in  such 
a  case  that  the  dividends  have  been  earned  and  are  prop- 
erly due  to  the  stockholders.  If  the  profits  that  are  to 
be  used  for  dividends,  however,  have  been  put  back  into 
the  property  or  into  any  sort  of  a  permanent  invest- 
ment, the  payment  of  the  dividends  will  involve  borrow- 
ing money.  Among  conservative  financiers  this  is 
universally  regarded  as  a  dangerous  practice.  Divi- 
dends ought  to  be  provided  for  in  advance  by  so  large 
an  accumulation  of  cash  that  their  payment  will  not 
unduly  reduce,  even  temporarily,  the  corporation's 
working  capital. 

A  third  frequent  cause  of  legal  insolvency  is  inability  j 
to  renew  medium  term  notes  or  refund  long-time  obliga- 
tions when  due.  This  situation  may  not  be  the  fault,  so 
much  as  the  misfortune,  of  the  corporation.  The  ob- 
ligation may  fall  due  during  the  height  of  a  crisis  when 
borrowing  of  money  on  any  terms  is  next  to  impossible. 
It  may  have  been  entirely  proper  to  issue  the  obligations 
in  the  first  place;  the  assets  may  be  far  more  than  suffi- 
cient in  value  to  cover  them;  and  yet  the  actual  cash  to 
meet  them  may  not  be  forthcoming.  We  shall  have  oc- 
casion in  the  following  pages  to  discuss  a  recent  case  of 
failure  and  reorganization  which  falls  within  this  class. 

231.  Two  methods  of  handling  insolvency — Bank- 
ruptcy and  dissolution, — There  is  so  much  confusion — 
not  only  in  the  public  mind,  but  even  among  lawyers — 
as  to  the  exact  nature  of  the  remedy  that  should  be  ap- 
plied when  a  corporation  gets  into  financial  difficulties, 
that  it  seems  proper  to  preface  our  study  of  corporate 

1-26 


40a  CORPORATION  FINANCE 

reorganization  by  a  brief  survey  of  the  legal  aspects  of 
insolvency,  receivership  and  bankruptcy.  Much  of 
what  is  said  in  this  chapter  will  apply  to  individual  pro- 
prietorships and  to  partnerships,  as  well  as  to  corpora- 
tions. Additional  information  on  the  topics  here  briefly 
treated  will  be  found  in  the  volume  on  Commeecial 
Law. 

The  reader  is  probably  already  aware  that  the  con- 
stitution of  the  United  States  confers  upon  Congress 
the  sole  authority  to  establish  a  uniform  law  as  to  bank- 
ruptcy procedure  for  the  whole  country,  and  that  the 
latest  expression  of  this  authority  is  found  in  the  Na- 
tional Bankruptcy  Act  of  1898.  Bankruptcy  may  be 
either  voluntary  or  involuntary.  It  may  be  asked  for 
by  an  insolvent  individual  or  partnership  in  order  to 
obtain  a  discharge  from  his  or  its  debts;  or  it  may  be 
asked  for  by  creditors  whose  claims  are  unsatisfied  in 
order  to  obtain  an  equitable  division  of  the  property  of 
the  bankrupt.  The  Bankruptcy  Act  provides  that  a 
corporation  cannot  become  a  voluntary  bankrupt,  but 
that  corporations  engaged  principally  in  manufactur- 
ing, trading,  printing,  publishing,  mining  or  mercai 
tile  pursuits,  owing  debts  to  the  amount  of  $1,000  o] 
over,  may  be  adjudged  involuntary  bankrupts.  The 
converse  of  this  statement  is  that  all  other  corporations,^^ 
including  those  engaged  in  banking^  and  transportatioi 
are  incapaMe  of  becoming  bankrupfs.  As  a  matter  oi 
fact,  it  is  seldom  to  the  interest  either  of  stockholderi§ 
or  of  creditors  to  force  a  corporation  into  bankruptcy 
Indeed,  the  chief  reason  that  may  lead  to  such  drasti^ 
action  is  the  desire  of  unsecured  creditors  to  prevenj 
secret  deals  and  transfers  of  the  corporation's  assets 
and  to  expose  any  past  irregularities  in  the  conduct  oi 
the  corporation.     Bankruptcy  is  especially  valuable  at 


INSOLVENCY  AND  RECEIVERSHIPS  403 

times  as  a  means  of  making  invalid  liens  or  judgments 
that  have  been  secured  by  favored  creditors  within  four 
months  of  the  period  of  bankruptcy. 

A  second  method  of  handling  the  affairs  of  an  in- 
solvent corporation  is  by  a  dissolution  of  the  corporation"! 
and  a  distribution  of  its  assets  to  creditors  and  share-/ 
holders.  This  method  is  even  more  infrequent  than 
bankruptcy  and  is  plainly  out  of  place  except  for  cor- 
porations, the  organization  and  good  will  of  which  are 
not  worth  saving. 

232.  A  third  method — Appointment  of  a  receiver. — 
A  third  method  is  the  use  of  what  is  known  in  law  as  a 
'^IHn  chancery."    The  objects  sought  to  be  obtained  by 
this  method  are,  first,  to  come  to  an  equitable  settlement 
between  the  corporation  and  its  creditors,  and,  second,  to 
preserve  the  corporation's  organization  and  continue  its 
business.     The  "bill  in  chancery"  is,  in  lay  language,  \ 
simply  a  petition  presented  to  a  court  of  equity  asking 
the  court  for  protection  and  supervision  of  the  corpora^'! 
tion's  property  and  business  until  a  settlement  of  the  j 
conflicting  claims  may  be  secured.     If  the  petition  is^ 
granted,  the  court  at  once  appoints  an  officer  responsible 
solely  to  the  court  known  as  a  "receiver,"  whose  busi- 
ness it  is  to  conduct  the  corporation's  affairs  until  he  is 
discharged.     The  petition  may  be  presented  by  any  one 
of  four  parties:    (a)    the  corporation  itself;    (b)    the 
stockholders;   (c)   secured  creditors;  or   (d)   unsecured 
creditors. 

A  petition  of  this  character  presented  by  a  corpora- 
tion in  its  own  name  is  unusual  and  instances  of  its  being 
granted  by  the  court  are  still  rarer.  It  is  also  somewhat 
unusual  to  find  petitions  by  stockholders  presented  and 
granted.  A  complaining  stockholder  is  usually  told  by 
the  court  that  his  proper  course,  if  he  is  dissatisfied  with 


404  CORPORATION  FINANCE 

the  management  of  the  corporation,  is  to  elect  new  di- 
rectors. Moreover,  a  complaint  by  a  stockholder  that 
his  corporation  is  insolvent  and  should  be  placed  m  a 
receiver's  hands  is  seldom  necessary,  for  in  such  a  case 
creditors  will  be  more  than  likely  to  take  the  initiative. 
Where  the  corporation  itself  is  willing  that  a  receiver 
should  be  appointed  the  petition  is  usually  presented  by 
friendly  unsecured  creditors.  This  is,  in  fact,  the  usual 
method  of  securing  what  is  known  as  a  "friendly  re- 
ceivership." It  is  doubtful,  however,  in  many  states, 
whether  an  unsecured  creditor  can  successfully  apply 
for  a  receivership  in  the  face  of  opposition  on  the  part 
of  a  corporation.  Secured  creditors  have  a  far  stronger 
case  and  a  petition  on  their  part  based  on  the  proved 
insolvency  or  mismanagement  of  the  corporation  is  not 
generally  denied. 

JJnlike  petitions  in  bankruptcy,  bills  in  chancery  may 
be  presented  either  in  the  federal  courts  or  in  any  of  the 
state  courts  which  have  jurisdiction.  Here  is  a  frequent 
cause  of  much  confusion  and  frequently  of  conflict  be- 
tween courts.  The  legal  questions  involved  are  entirely 
too  complicated  and  technical  to  be  discussed  in  this 
chapter.  All  that  need  be  said  is  that  where  large  in- 
ter-state corporations  are  involved  the  tendency  is  grow- 
ing to  apply  to  the  federal  courts  for  relief.  One  reason 
is  that  the  judges  of  these  courts  are  especially  familiar 
with  cases  of  this  kind;  another  reason  of  still  greater 
importance  is  that  federal  judges  in  different  parts  of 
the  country  work  together  more  harmoniously  than  do 
the  judges  of  different  states. 

233.  Duties  of  a  receiver, — If  the  corporation  is  cai 
rying  on  simply  a  trading  business  and  goes  into  bank- 
ruptcy, the  activities  of  the  receiver  in  bankruptcy  will 
be  comparatively  simple.     He  will  dispose  of  the  assets 


INSOLVENCY  AND  RECEIVERSHIPS  405 

as  rapidly  as  he  can  and  will  use  the  funds  thus  obtained, 
so  far  as  they  will  go,  to  settle  with  creditors.  There 
may  be  a  considerable  waste  in  this  process,  for  the 
established  trade  and  business  connections  of  the  failed 
company  will  go  for  nothing.  Yet,  on  the  whole,  it  is 
the  quickest  and  most  certain  method  of  satisfying  the 
obligations  of  the  company,  and  it  is  usually  followed. 
Unless  the  corporation's  borrowings  have  been  far  in 
excess  of  the  value  of  its  tangible  assets,  the  obligations 
will  be  met  and  the  loss  will  all  be  borne  by  the  stock- 
holders. In  an  ordinary  bankruptcy  the  stockholders' 
interests  are  very  little  considered. 

Where  the  failed  corporation  is  a  large  manufactur- 
ing or  railroad  company  with  a  great  amount  of  fixed 
capital  and  a  receiver  is  appointed  by  a  court  of  equity, 
his  duties  are  entirely  different.  He  has  as  his  object 
in  this,  as  in  the  former  case,  the  payment  of  corporate 
obligations.  It  is  very  seldom,  however,  that  this  ob- 
ject, when  the  corporation  has  large  fixed  assets,  can  be 
attained  by  the  sale  of  these  assets.  Ordinarily  there 
is  no  one  to  buy  them  except  at  a  tremendous  sacrifice. 
It  would  evidently  be  quite  impossible  to  find  cash 
buyers  for  the  millions  of  dollars  of  property  of  any  of 
the  great  industrial  combinations  or  of  any  of  the  great 
railroads.  Therefore,  the  receiver  is  permitted  in  such 
a  case  to  go  on  with  the  business.  'No  profitable  ac- 
tivities of  the  concern  are  allowed  to  cease.  It  goes  on 
manufacturing  or  transporting,  or  whatever  its  business 
may  be,  under  the  receiver's  administration,  just  as  it 
did  under  the  administration  of  its  own  officers.  As  the 
holders  of  claims  against  the  failed  corporation  cannot 
hope  for  immediate  payment  in  cash,  a  settlement  with 
them  must  be  made  in  some  other  manner — usually 
through    a   reorganization,    a   subject   to   which   con- 


406  CORPORATION  FINANCE 

siderable  attention  is  given  in  the  following  chapters. 

234.  Receivers  powers. — The  receiver  is  a  very 
powerful  official.  So  long  as  no  actual  fraud  or  obvious 
mismanagement  on  his  part  is  proven,  he  is  at  liberty 
to  make  such  disposition  of  the  assets  and  earnings 
under  his  charge  as  he  sees  fit.  He  may  use  his  power 
altogether  for  the  benefit  of  the  creditors,  or  he  may  use 
it  in  part  also  for  the  benefit  of  the  stockholders.  If 
he  has  the  latter  object  in  view,  he  will  naturally  do  what 
he  can  to  delay  a  settlement  until  a  favorable  period  ar- 
rives and  will  thus  preserve  as  much  of  the  property  as 
possible  for  the  stockholders. 

In  view  of  his  power  it  is  always  very  important  to 
the  stockholders — and  frequently  more  equitable  to 
every  one  concerned — to  have  a  receiver  of  their  own 
choosing  appointed.  In  recent  years  it  has  become  cus- 
tomary for  corporations  which  are  getting  into  diffi- 
culties to  secure  from  the  court  the  appointment  of  what 
are  generally  known  as  "friendly"  receivers.  Fre- 
quently the  friendly  receivers  are  officers  of  the  corpo- 
ration. In  order  to  get  this  result  there  must  be 
collusion  between  one  or  more  of  the  creditors  and  the 
corporate  officials.  The  creditor  or  creditors  and  the  of- 
ficials go  secretly — often  at  dead  of  night — to  some 
judge  who  has  jurisdiction;  the  creditor  complains  thai 
his  debt  is  unpaid  and  the  officials  confess  insolvency: 
then  the  creditor  asks  for  the  appointment  of  some  mai 
previously  agreed  upon  to  act  as  receiver,  and  the  judg< 
then  and  there  duly  appoints  him.  Of  course,  th< 
judge  must  be  fully  aware  of  this  scheme  and  must 
approve  it.  On  account  of  the  conflicting  jurisdictioi 
of  our  state  and  federal  courts,  however,  it  is  usuall; 
a  very  easy  matter  to  find  one  among  the  several  judges 
with  the  proper  authority  who  will  do  what  is  wantec 


INSOLVENCY  AND  RECEIVERSHIPS  407 

It  will  not  do  to  say  ofF-hand  that  in  every  case  the 
appointment  of  friendly  receivers  is  absolutely  wrong, 
or  that  the  judge  who  makes  the  appointment  is  corrupt. 
As  has  been  intimated,  insolvency  sometimes  results 
from  causes  beyond  the  control  of  corporate  officials 
and  hasty  action  on  the  part  of  receivers  would  cause 
heavy  unnecessary  loss.  We  cannot  absolutely  con- 
demn, therefore,  either  the  officials  who  request  the  ac- 
tion or  the  judge  who  complies  with  the  request.  Nev- 
ertheless, the  transaction,  being  secret  and  more  or  less 
irregular,  seldom  reflects  credit  on  any  one  concerned. 

Since  the  receiver,  however  he  may  be  appointed,  is  a 
court  officer,  his  expenses  are  court  expenses  and  until 
paid  constitute  a  lien  on  the  corporate  assets  that  goes 
ahead  of  all  other  claims.  This  fact  has  already  been 
referred  to  in  the  discussion  of  receivers'  certificates. 
Receivers'  certificates  may  be  issued  in  order  to  secure 
funds  for  practically  any  purpose  that  the  receiver 
deems  proper.  The  funds  may  be  used  to  purchase  new 
supplies  or  equipment  or  to  improve  and  extend  the 
property.  If  the  development  of  a  corporation  has  been 
greatly  hampered  by  lack  of  funds  a  receivership  may 
thus  prove  a  very  desirable  thing,  for  the  receiver  has 
an  opportunity  to  put  the  company  into  prime  condi- 
tion. Receiverships  have  been  known  in  this  way  to 
prove  the  salvation  of  an  insolvent  concern. 

The  receiver  usually  charges  and  gets  a  very  large 
fee  for  his  services.  There  has  been  much  complaint 
and  agitation  at  times  on  this  account,  especially  in 
connection  with  bank  receiverships.  The  size  of  re- 
ceiver's fees  during  the  panic  year,  1907,  in  New  York 
City  became  almost  a  public  scandal.  This,  however, 
brings  up  questions  which  do  not  properly  fall  within 
the  scope  of  corporation  finance. 


CHAPTER  XXIX 


PRINCIPLES  OF  REORGANIZATION 


235.  Reasons  for  reorganization, — There  are  t^p 
general  classes  of  reorganization:  first,  those  that  are 
necessary  as  the  result  of  insolvency;  second,  those  that 
prove  desirable  in  order  to  readjust  the  securities  and 
the  means  of  cojQtrol  of  a  company.  The  prindples 
of  reorganization  also  are  somewhat  differently  applied 
in  railroads  and  in  manufacturing  concerns.  In  order 
to  bring  out  these  distinctions  we  shall  take  up  in  the 
following  chapter  three  typical  reorganizations :  First, 
of  an  insolvent  railroad;  second,  of  an  insolvent  indus- 
trial; and,  third,  of  a  solvent  railroad.  In  this  chapter 
our  attention  will  be  confined  to  the  general  principles 
which  apply  in  all  kinds  of  reorganizations. 

The  reasons  for  reorganization  in  lieu  of  a  simple 
sale  of  property  have  already  been  alluded  to.     In  order 
to  make  them  plain,  however,  we  should  give  them  some 
further  consideration.     The  complexity  of  the  financial 
organization  of  a  large  corporation  is  one  factor  to  takej 
into  account.     In  the  case  of  a  railroad  the  parent  com-j 
pany  will  probably  own  the  securities  of  a  numBer  of  1 
subsidiary  companies.     Each  one  of  these  subsidiary 
companies  will  have  one  or  more  mortgages  on  its  line. 
The  stock  and  perhaps  some  of  the  bonds  of  the  sub- 
sidiary companies  will  be  owned  by  the  parent  company 
and  will  perhaps  be  posted  as  security  for  a  collateral 
trust  bond  issue.     The  parent  company  will  perhaps 
own  a  main  line  and  several  branch  lines,  and  will  havej 

408 


PRINCIPLES  OF  REORGANIZATION  409 

outstanding  mortgage  bonds  based  on  each  of  the  branch 
lines,  mortgage  bonds  based  on  the  terminals  and  real 
estate  holdings,  and  very  likely,  in  addition,  a  general 
mortgage  bond  issue  to  cover  whatever  property  is  left. 
Then  there  will  probably  be  preferred  and  common 
stock  and  short-time  claims,  including  accounts  payable, 
accrued  wages  and  bank  loans.  Such  a  group  of  cor- 
porate relationships  and  obligations  may  be  taken  as 
typical.  They  are,  in  fact,  not  half  so  complex  as  the 
internal  organization  of  many  large  railroad  and  in- 
dustrial companies. 

In  contrast  to  this  complicated  financial  scheme  we 
find  the  railroad  property  to  be  practically,  for  operat- 
ing purposes,  an  indivisible  unit.  The  word  "indi- 
visible" as  here  used  does  not  mean,  of  course,  that  the 
property  is  actually  physically  merged  into  one.  It 
would  be  possible  for  the  branch  line  bondholders  to 
mark  out  and  segregate  their  property  and  take  it  for 
themselves ;  for  the  terminal  bondholders  to  do  the  same ; 
for  the  main  line  bondholders  to  do  the  same ;  and  so  on. 
It  is  indivisible,  however,  in  the  sense  that  a  division  of 
the  property  would  destroy  most,  if  not  all,  of  its  value. 
This  statement  applies  only  to  a  well-constructed,  uni- 
fied railroad  system.  If  any  part  of  the  system  is  su- 
perfluous, it  may  be  lopped  off  and  taken  by  its  own 
bondholders.  This,  for  instance,  was  the  case  with  the 
St.  Louis  and  San  Francisco  Railroad,  which  was 
owned  by  the  Atchison,  Topeka  and  Santa  Fe,  up  to 
the  bankruptcy  of  the  latter  road  in  1893,  and  was  then 
taken  over  by  the  St.  Louis  and  San  Francisco  bond- 
holders. The  same  thing  was  true  of  the  Oregon  Short 
Line,  which  was  temporarily  cut  off  from  the  Union 
Pacific  System  in  the  bankruptcy  of  1893. 

Assuming  that  a  failed  corporation  possesses  prop- 


410  CORPORATION  FINANCE 

erty  which  is  commercially  indivisible,  the  question  that 
arises  in  case  of  bankruptcy  is,  What  arrangement  can 
be  made  to  prevent  the  property  from  being  split  up 
into  segments  by  the  conflicting  claims  of  the  various 
security-holders  ?  How  can  it  be  held  together,  put  back 
on  its  feet  and  restored  to  its  rightful  position  as  a 
valuable  profit-making  business?  Every  bondholder, 
as  well  as  every  stockholder,  is  keenly  interested  in  find- 
ing the  right  answer.  The  value  of  any  bond,  as  has 
already  been  shown,  depends  in  large  part  on  the  earn- 
ing power  and  prosperity  of  the  issuing  corporation. 
236.  The  formation  of  committees, — In  the  process 
of  getting  an  answer  the  first  step  is  to  ascertain  as 
nearly  as  possible  the  exact  status  of  each  of  the  cor- 
poration's obligations.  Usually  this  task  is  left  to  the 
receivers  or  to  such  persons  as  are  selected  to  act  as  a 
reorganization  committee.  Each  class  of  bondholders 
chooses  representatives  whose  duty  it  is  to  represent  the 
interests  of  that  particular  class.  These  representatives 
are  usually  called  a  committee  and  are  selected  in  va- 
rious ways.  Sometimes  a  meeting  of  the  bondholders  of 
one  class  is  called  and  the  members  of  the  committee  are 
elected.  Sometimes  banking  houses  which  have  under- 
written one  or  more  of  the  bond  issues  come  forward 
and  offer  to  serve  on  reorganization  committees.  Gen- 
erally these  members  of  tlie  committee  are  self-chosen, 
and  are  of  such  character  and  standing  that  they  readily 
secure  the  support  of  their  fellow  bondholders.  Shortly 
after  the  breakdown  of  a  big  corporation  it  is  quite 
customary  for  one  of  the  heavy  bondholders  of  each 
class  to  send  a  circular  letter  to  the  other  bondholders 
of  that  class  stating  that  they  should  be  represented  in 
the  pending  negotiations  and  asking  that  they  place 
their  interests  in  his  Iiaiids.     Usually  he  states  in  the 


PRINCIPLES  OF  REORGANIZATION^  411 

circular  that  his  only  interest  in  the  matter  is  to  secure 
the  rights  of  the  persons  to  whom  he  appeals  and  that 
he  will  act  in  good  faith  with  that  sole  object  in  view. 
The  bondholders  signify  their  consent  by  depositing 
their  bonds  with  some  stipulated  trust  company.  If  a 
majority  of  the  bonds  of  a  given  class  are  deposited,  the 
self-appointed  representative  or  committee  is  authorized 
to  act  on  their  behalf.  We  should  bear  in  mind,  how- 
ever, that  the  committee^  authority  Js  only  that  of  a 
representative.  It  cannot  bind  the^bondholders  to  any 
terms  whatever.  Whether  the  bondholders  accept  the 
plan  which  their  committee  approves  or  not  will  depend 
largely  on  their  estimate  of  the  character  and  intelli- 
gence of  the  members  of  the  committee. 

Within  a  few  days  after  an  important  insolvency  is 
announced,  there  will  usually  come  into  existence  a 
number  of  different  duly  authorized  committees,  one 
representing  the  general  mortgage  bondholders,  one  the 
bondholders  of  each  of  the  subsidiary  companies,  one 
the  debenture  bondholders,  if  there  is  such  an  issue,  and 
so  on.  Ordinarily  it  is  not  necessary  for  the  bona  fide 
first  mortgage  bondholders  to  organize.  They  are  so 
well  protected  that  they  can  afford  to  sit  quiet  while  the 
other  claimants  fight  it  out.  Usually  also  the  stock- 
holders do  not  organize.  They  have  practically  no 
voice  in  the  reorganization,  anyway,  if  the  receivership 
is  unfriendly ;  if  it  is  friendly  their  interests  are  already 
protected.  Sometimes,  however,  the  stockholders  as  a 
body,  or  the  preferred  and  common  stockholders,  each 
acting  as  a  class,  will  appoint  committees  of  their  own 
when  burdensome  assessments  seem  imminent. 

Once  the  committees  are  appointed  the  "jockeying 

for  position"  and  the  arguments  pro  and  con  as  to  the 

litrength  of  each  of  the  competing  claims  on  the  corpora- 


413  CORPORATION  FINANCE 

tion's  assets  begin.  If  many  different  claims  are  in- 
volved, it  will  probably  be  necessary  for  the  committee 
of  each  class  of  security -holders  to  appoint  a  single  rep- 
resentative and  have  these  representatives  form  a 
general  reorganization  committee.  It  is  the  dutyxiE. 
this  committee  to  discuss  terms  of  reorganization  and 
finally  To  agree  upon  a  plan  which  may  be  submitted  to^ 
the  security-holders. 

237.  Why  not  foreclose. — The  reader  may  well  in- 
quire at  this  point  why  the  bondholders  as  a  whole  or 
some  class  of  bondholders  do  not  foreclose  and  sell  under 
their  mortgage  and  thus  get  enough  cash  to  meet  their 
own  claims,  or  failing  that,  bid  in  the  property  for  them- 
selves. It  may  correctly  be  suggested  in  this  connec- 
tion that  for  the  purpose  of  buying  the  property  when 
it  is  sold,  each  bond  would  be  accepted  at  its  par  value. 

This  question  has  already  been  answered  in  part  by 
the  statement  in  the  last  chapter  to  the  effect  that  it 
would  be  next  to  impossible  to  sell  a  large  corporation 
to  an  outsider  for  cash,  because  the  amount  involved  is 
too  large.  Besides,  an  outsider  who  wished  to  get  con- 
trol of  the  property  could  accomplish  his  purpose  much 
more  economically  by  buying  the  securities  of  the  failed 
corporation  at  the  low  prices  at  which  they  naturally 
sell  during  the  period  of  reorganization. 

In  answering  the  second  part  of  the  question  we  must 
consider  that  the  bondholders  whose  securities  are  close 
to  the  property  would  not  have  anything  to  gain  by  a 
sale.  Their  principal  and  interest,  presumably,  are  well 
protected  and  they  could  not  by  any  process  of  juggling 
get  more  than  principal  and  interest.  With  the  junior 
mortgage  bondholders  the  situation  is  somewhat  differ- 
ent. They  might  at  times,  if  the  reorganization  scheme 
appears  unfavorable  to  them,  have  something  to  gain 


I 


PRINCIPLES  OF  REORGANIZATION  413 

by  compelling  foreclosure,  and  bidding  in  the  property. 
In  this  case,  however,  they  might  be  forced  to  settle  all 
the  claims  that  rank  ahead  of  their  own  in  cash,  which 
would  ordinarily  be  too  large  an  undertaking.  How- 
ever, the  possibility  of  such  action  on  their  part  is  always 
recognized  by  the  reorganization  committee  and  their 
claims  are  in  consequence  treated  with  greater  respect 
than  they  would  otherwise  command.  The  result  is 
that  foreclosure  proceedings  are  usually  only  a  form. 
After  reorganization  plans  have  been  completed  fore-_^ 
closure  is  simply  a^  method  of  transferring  the  property 
of  the  old  corporation  to  a  new  corporation. 

238.  Problems  confronting  the  reorganization  com- 
mittee. — The  reorganization  committee,  then,  once 
formed  has  a  reasonably  free  hand.  At  the  same  time 
it  must  act  with  due  circumspection  in  order  not  to 
arouse  the  hostility  of  any  powerful  body  of  security- 
holders. It  must  treat  everybody  with  apparent  jus- 
tice; it  must  reconcile  conflicting  claims  and  interests. 
The  success  of  whatever  plan  of  reorganization  it  adopts 
will  depend  upon  the  extent  to  which  the  plan  is  ac- 
cepted by  security-holders.  As  noted  above,  the  first 
and  perhaps  jowst^important  dut^ 
therefore,  is  to  f OTm  some  working  estimate  of  the^rela- 
tive  values  of  the  different  classes  of  securities^_^ 

First,  they  must  consider  whether  there  has  been  an 
impairment  of  assets  and  earnings  sufficient  to  affect 
the  first  mortgage  bonds.  Usually  this  question  may 
be  answered  in  the  negative.  If  an  affirmative  answer 
has  to  be  given,  any  attempt  at  reorganization  might  as 
well  be  given  up,  for  nothing  can  be  done  except  to 
allow  the  first-mortgage  bondholders  to  take  whatever 
property  is  left.  Assuming  that  the  first  mortgage 
bondholders  are  still  in  an  entirely  safe  position,  the  re- 


414  CORPORATION  FINANCE 

organization  committee  next  considers  the  situation  of 
the  bondholders  secured  by  mortgages  on  outlying  or 
small  sections  of  property.  Mortgages  of  this  nature 
on  railroads  are  usually  divisional,  terminal,  branch  line 
or  real  estate ;  with  industrial  corporations  there  may  be 
mortgages  on  unessential  plants  or  property.  For  in- 
stance, a  consolidation  may  originally  have  taken  in 
twenty  plants,  and  may  have  found  ten  of  the  plants 
so  uneconomical  that  it  has  transferred  almost  all 
their  business  to  the  other  ten;  or  a  merchandising  cor- 
poration may  have  gone  into  general  trucking;  or  a 
paper  mill  may  own  a  great  expanse  of  forest  land,  not 
all  of  which  is  essential  to  its  business.  In  such  cases 
the  outlying  mortgage  bondholders  may  be  allowed  to 
take  their  property,  and  their  claims  may  then  be  elim- 
inated from  further  consideration.  It  mayjwell^  b^^on 
the  other  hand,  ttiat  the  separate  pieces  of  property  so 
mortgaged  are  highly  essential,  in  which  case  the  bond- 
Tiolders  would  be  able  to  insist  on  a  settlement  of  their 
claims  in  full.  Thus  a  railroad  could  not  well  get  along 
without  its  terminals  or  without  equipment,  and  the  re- 
organization committee  would  have  to  allow  full  value 
to  all  bonds  based  upon  such  property.  A  manufac- 
turing corporation  may  derive  its  chief  profits  indirectly 
from  its  control  of  the  sources  of  raw  materials,  in  which 
case  the  reorganization  committee  would  arrange  to  pay 
bonds  based  on  such  property^n  full,  even  if  the  prop- 
perty  taken  in  itself  were  not  of  ^reat  value.  Disputes 
are  bound  to  arise  in  connection  with  many  of  these 
claims  on  specific  pieces  of  property. 

A  railroad  branch  line,  for  instance,  may  earn  very 
little  revenue  for  itself,  according  to  the  railroad's 
method  of  figuring,  and  may  have  absolutely  no  value 


PRINCIPLES  OF  REORGANIZATION  415 

except  as  an  adjunct  to  the  failed  railroad.  Yet  it  may- 
turn  over  to  that  railroad  a  large  and  highly  profitable 
traffic.  The  bondholders  will  naturally  point  to  this 
traffic  as  justification  for  a  demand  that  their  claims  be 
paid  in  full.  The  other  interests  involved  will  point  to 
the  isolated  position  of  the  branch  line  apart  from  the 
railroad  as  sufficient  ground  for  attaching  very  little 
value  to  the  branch  line  bonds.  Usually  a  compromise 
is  necessary.  Both  parties  have  much  to  lose  and  noth- 
ing to  gain  by  a  permanent  separation  of  main  and 
branch  lines.  Each  side  wiUjirobably  "MuflT"  so  far  as 
it  dares,  and  each  will  finally  concede  something. 

The  reorganization  committee  next  takes  up  the 
claims  of  the  general  mortgage  bondholders  and  en- 
deavors to  ascertain  how  much  assets  and  earnings  are 
left  for  them  after  satisfying  prior  claims.  This  may 
or  may  not  be  a  particularly  difficult  task;  that  all  de- 
pends on  the  nature  and  complexity  of  underlying 
mortgages*  The  value  of  the  general  mortgage  bonds 
will  depend  to  a  great  extent  on  the  wording  of  the 
mortgage.  It  may  cover  only  such  property  as  was  in 
existence  when  the  mortgage  was  drawn  or  may 
contain  an  "after-acquired  property"  clause.  Next,  in 
order  of  consideration  are  the  debenture  bonds.  As 
these  bonds  are  merely  claims  on^earnings,  not  Qn_assetSa_ 
the  reorganization  committee  in  estimating  their  value 
will  try  to  find  out  how  much  of  the  corporation's 
income  is  left  for  them  after  paying  prior  interest 
charges. 

Finally,  the  reorganization  committee  will  consider 
what  must  be  done  f o^Jhe  preferred  and  common  stock- 
holders. Sometimes  in  heavily^over-capitalized  concerns 
the  cominoii_stockjyill Jbe  wiped  out  absolutely.     It  is 


416  CORPORATION  FINANCE 

more  usual,  however,  to  try  to  preserve  something  for 
the  stockholders,  with  the  proviso,  usually,  that  the  stock- 
holders pay  certain  cash  assessments. 

239.  Necessity  for  cash, — Another  factor  in  reorgan- 
ization not  previously  mentioned  is  the  current  or 
floating  debt  of  the  corporation.  This  debt  may  take 
the  form  either  of  loans  and  medium-term  notes  having 
specific  security  or  of  unsecured  obligations,  such  as 
accounts  payable.  Whether  secured  or  unsecured,  this 
floating  debt  must  be  paid  in  cash;  otherwise  the 
creditors  of  this  class  will  certainly  attacks  the  assets  of 
the  corporation  and  eff'ectually  prevent  the  success  of 
reorganization.  The  only  path  of  escape  from  the 
floating  debt  would  be  through  foreclosure  and  sale  of 
the  property,  and  this  path  does  not  lead  to  reorganiza- 
tion. The  reorganization  committee,  therefore,  must  b^ 
soniejneans  raise  cash  suflicient  to  meet  all  this  floating^ 
debt  in  order  that  the  reorganized  company  may  begin 
business.  Furthermore,  there  must  be  enough  casli 
left  over  to  provide  the  reorganized  company  with  a 
Tair  workings  capital;  otherwise  it  will  begin  at  once 
to  get  into  new  difficulties,  as  is  well  illustrated  by  the 
career  of  the  Detroit,  Toledo  and  Ironton  Railroad 
reviewed  in  the  last  chapter.  The  £ommittee  also,  if  it 
desires  to  have  the  reorganized  company  prosper,  must 
^e  to  it  that  its  fixed  charges  are  not  larger  than  its 
jninimum  net  earnings.  We  have  thus,  four  main 
\  objects  of  every  reorganization:  (a),  to  pay  the  float- 
^  ingdebt;  (b),  to  provide  working  capital;  (c),  to  bring 
the  property  up  to  at  least  normal  efficiency;  (d),  to 
J  reduce  fixed  charges  below  minimum  earnings. 

The  first  three  of  these  objects  require  cash  in  large 
amounts;  especially  is  this  true  since  a  company  which 
is  approaching  insolvency  almost  always  lets  its  ac- 


PRINCIPLES  OF  REORGANIZATION  4.17 

counts  payable  accumulate,  its  working  capital  decline, 
and  its  property  become  impaired.  Of  course,  this  may 
not  be  the  situation  at  all  if  the  corporation  has  simply 
met  with  some  temporary  reverse,  which  brought  it 
into  a  condition  of  legal  insolvency.  In  such  a  case  the 
problems  of  reorganization  are  comparatively  simple. 
As  a  general  thing,  however,  the  reorganization  com- 
mittee will  find  it  necessary  to  raise  cash  from  every 
available  source.  As  sufficient  cash  makes  the  attain- 
ment of  the  first  three  objects  named  above  easy,  we  may 
say  that  the  reorganization  committee  will  consider  two 
fliings  of  prime  importance:  first,  to  raise  cash;  second^ 
to^reduce  Sked  charges. 

240.  Raising  cash  by  assessments, — There  are  three 
possible  methods  of  securing  cash:  first,  by  the  sale  of 
some  of  the  corporate  property;  second,  by  the  issue  of 
new  securities;  third,  by  assessments  on  the  security-^ 
holders.  The  first  method  is  almost  never  practicable. 
inEe  corporation  possesses  outlying  property  non- 
essential to  its  business,  it  is  more  than  likely  that  this 
property  has  been  heavily  mortgaged  and  must  be 
turned  over  to  the  mortgagees.  The  second  method,  as 
a  general  thing,  is  equally  impracticable.  Obviously 
a  corporation  is  not  likely  to  fail  unless  it  has  already 
exhausted  its  borrowing  power,  and  the  sale  of  the  stock 
of  an  insolvent  corporation  is  out  of  the  question. 
These  considerations  again  do  not  necessarily  apply 
when  the  corporation  is  not  a  true  insolvent  but  has 
merely  suffered  a  temporary  setback.  Even  in  true 
insolvency  cash  is  sometimes  raised  through  consider- 
able issues  of  receivers'  certificates,  which  in  reorgan- 
ization are  funded  along  with  the  first  mortgage  bonds 
into  a  new  first  mortgage  issue.  At  times  this  may  be 
entirely  proper  and  expedient.     The  efficiency  of  the 

1—27 


418  CORPORATION  FINANCE 

corporation's  assets  may  have  become  impaired  and  a 
little  cash  raised  by  receivers'  certificates  may  put  them 
into  such  a  condition  as  to  enhance  its  earning  power 
vastly  more  than  the  amount  of  the  extra  fixed  charges 
thus  imposed. 

The  third  method— assessment  on  the  security-holders 
— ^is  almost  universal.  Naturally  the  first  and  he^iesi 
assessments  fall  on  the  common  and  preferred  stock- 
holders. The  possibility  of  raising  cash  by  this  method 
is  limited  by  the  stockholders'  estimate  of  the  value  of 
the  stock  of  the  reorganized  company.  They  are  given 
the  choice  either  of^jpaying  the  assessment  or  of  fgr^ 
j[eiting  their  equity  in  the  corporation's  assets,  if  the 
assessment  is  made  too  high  evidently  the  stockholder 
will  choose  to  forfeit  whatever  rights  remain  to  him, 
rather  than  to  pay  what  is  asked.  The  reorganization 
committee  will  therefore  endeavor  to  keep  the  assess- 
ment down  to  what  it  considers  a  reasonably  low  figure. 

Under    these    conditions    the    average    stockholder 
almost  always  finds  it  worth  while  to  pay  his  assessment 
and  retain  an  interest  in  the  company.     If  he  cannot 
raise  the  necessary  cash  he  will  sell  his  stock  in  the  ope: 
market  for  whatever  it  will  fetch  to  someone  who  hi 
both  the  courage  and  the  means  to  meet  the  assessment 
It  is  almost  always  true  that  the  stock  of  a  failed  com- 
pany sells  at  an  abnormally  low  figure.     It  is  also  tru( 
that  within  a  short  period  after  reorganization,  the  stock^ 
of  the  reorganized  company  sells  at  a  price  considerably] 
above  the  price  of  the  old  stock  during  the  receivership] 
plus  the  assessment.     In  other  words,  experience  has] 
demonstrated  that  the  stockholder  will  do  better  if  h 
sticks  with  the  company  than  if  he  forfeits  or  sells  hisj 
shares.     By    paying   the    assessment   he   reduces 
losses. 


I 


PRINCIPLES  OF  REORGANIZATION  419 

Sometimes,  although  rarely,  it  becomes  necessary  to 
assess  the  junior  bondholders  also.  It  seems  strange 
that  a  creditor  of  the  corporation  should  ever  be  forced 
to^y  an  assessment  in  order  tq^remain  a  creditor,  yet 
theTogic  of  the  situation  compels  the  bondholders, 
when  they  are  thus  assessed,  to  accept  it  with  as  good 
grace  .as^  they  can  muster.  The  bondholders  will  not 
and  cannot  equitably  be  compelled  to  pay  unless  the 
burden  is  too  heavy  for  the  stockholders  to  carry  alone. 
If  the  amount  of  cash  needed  is  so  large  that  most  of 
the  stockholders  would  rather  lose  their  equity  in  the 
property  than  furnish  their  proportion  of  the  cash,  the 
bondholders  find  themselves  in  an  unpleasant  dilenmia. 
Either  they  must  take  some  of  the  burden  off  the  stock- 
holders' shoulders,  or  they  must  take  the  whole  burden 
themselves  and  eliminate  the  stockholders  altogether. 
Almost  always  they  prefer  the  former  alternative. 
When  the  Atchison,  Topeka  and  Santa  Fe  Railroad, 
for  instance,  was  reorganized  in  1894,  the  cash  require- 
ments were  so  large  that  each  stockholder  would  have 
been  compelled  to  pay  in  the  neighborhood  of  $14  per 
share,  and  it  was  more  than  doubtful  if  that  stock  of  the 
reorganized  company  was  worth  this  amount.  The  re- 
organization committee,  therefore,  imposed  $4  of  the 
assessment  on  the  junior  bondholders. 

Usually  the  cash  needed  by  the  company  is  not 
required  at  once,  and  the  terms  of  payment  of  the 
assessments  may  therefore  be  made  fairly  easy,  thus 
reserving  some  of  the  cash  resources  of  the  corporation. 
Another  means  of  providing  funds  for  future  use  is  to 
base  the  bond  issues  of  the  reorganized  company  on  a 
limited  open-end  mortgage,  so  that  the  company  need 
not  be  hampered  for  many  years  to  come  by  a  dearth  of 
funds. 


420  CORPORATION  FINANCE 

241.  Reducing  fixed  charges, — Having  provided  the 
reorganized  company  with  sufficient  cash,  the  reorgan- 
ization committee  now  takes  up  its  final  and  most  difficult 
problem,  reduction  of  fixed  charges.  The  fixed  charges 
that  may  be  eff*ected  are  of  three  kinds:  guarantees, 
rentals  and  interest.  A  company  may  be  dissolved 
in  reorganization,  in  which  case  it  is,  of  course,  released 
from  its  previous  contracts  and  the  reorganized  com- 
pany may  or  may  not  renew  them.  If  guarantees 
of^interest^iid^ividends  on  subsidiary  company  securi- 
ities  have  proved  burdensome  and  unprofitable,  the 
reorganization  committee  has  an  opportunity  to  dis- 
pense with  them.  It  does  not  follow  that  the  com- 
mittee will  always  take  this  action.  The  guarantee 
may  be  necessary  in  order  to  hold  control  of  the  sub- 
sidiary companies.  Frequently,  however,  the  holders 
of  the  guaranteed  stock  and  bonds  will  submit  to  a  re- 
duction of  the  guarantee  rather  than  take  back  their 
property. 

Much  the  same  thing  may  be  said  of  Rentals..  The 
owners  of  abased  property  would  ordinarily  have  great 
difficulty  in  leasing  it  to  any  other  corporation  and  could 
not  very  well  operate  it  themselves.  Especially  is  this 
true  when  the  leased  property  has  been  constructed  in 
the  interest  of  the  failed  corporation.  The  owners, 
therefore,  have  practically  no  choice  in  the  matter. 
They  must  submit  to  any  reasonable  reduction  that  the 
reorganization  committee  demands. 

Far  more  important  usually  in  its  effect  on  fixed 
charges  is  the  substitution  for  the  jpterest-bearing  securi- 
ties  of  the  old  corporation  of  dividend-paying  securities 
of  the  new  corporation.     Sometimes,  also,  old  securitie^^B 
which  bear  interest  at  a  high  rate  are  converted  into  ne^^W 
securities  bearing  interest  at  a  low  rate.     The  result  of 


PRINCIPLES  OF  REORGANIZATION.  421 

this  readjustment,  if  the  reorganization  is  to  prove  suc- 
cessful, must  be  to  bring  the  total  fixed  charges  below  the 
net  earnings  of  the  corporation  even  in  the  worst  years. 
Ordinarily  the  reorganization  committee  wiU  first  make 
a  conservative  estimate  of  the  lowest  earnings  likely 
to  occur  in  the  future  and  will  cut  down  interest 
charges  accordingly.  Of  course  this  reduction  is  not 
proportionate  on  all  the  bond  issues,  but  is  adjusted  in 
accordance  with  the  relative  strength  of  the  various 
claims  against  the  corporation,  as  already  indicated. 

One  of  the  great^  adyanta^es^qf  reorganization  is 
the  possibility  which  it  affords  of  unifying  and  simpli:L 
f  ying  the  complicated  and  sometimes  conflicting  obliga- 
tions that  have  been  imposed  at  various  times.  The 
--reorganization  committee  will  usually  arrange  for  a 
few  comprehensive,  well-defined  mortgages  in  place  of 
the  numerous  mortgages  previously  existing  and  will 
increase  the  amount  authorized  under  each  mortgage. 
This  principle,  however,  cannot  be  extended  too  far. 
The  committee  cannot,  for  instance,  without  getting 
into  legal  difficulties,  absorb  any  of  the  old  bond  issues, 
interest  on  which  has  unquestionably  been  earned  for 
several  years  previous.  The  old  first  mortgage  issue 
and  the  first  mortgage  bonds  on  highly  important 
specific  pieces  of  property  will  therefore  generally  be 
left  untouched.  On  top  of  them,  however,  the  com- 
mittee may  impose  a  new  general  mortgage  bond 
issue  of  large  size  sufficient  to  refund  all  the  existing 
issues  that  are  to  be  absorbed,  to  refund  the  old  first 
mortgage  bonds  when  they  finally  fall  due  and  to  pro- 
vide for  necessary  improvements  and  extensions.  This 
general  mortgage  issue  will  be  designed  evidently  to 
become  in  time  a  first  lien  on  all  the  corporation  prop- 
erty.    For  these  new  general  mortgage  bonds  the  old 


423  CORPORATION  FINANCE 

junior  bonds  wiU  be  exchanged  on  such  terms  as  may  be 
finally  agreed  to. 

242.  Capitalization  of  the  reorganized  corporation. 
— Assuming  that  the  reorganization  committee  has 
succeeded  in  determining  the  relative  values  of  the 
various  issues  of  mortgage  bonds,  it  may  now  proceed 
to  a  corresponding  allotment  of  the  new  general 
mortgage  bonds.  Suppose,  for  instance,  that  there  had 
been  outstanding  $1,000,000  second  mortgage  bonds, 
$500,000  branch  line  bonds  and  $1,500,000  debenture 
bonds,  and  that  the  new  general  mortgage  issue  avail- 
able for  exchange  is  fixed  on  the  basis  of  the  lowest 
earnings  at  $2,000,000;  suppose  also  that  the  reorgan- 
ization committee  estimates  the  first-named  issue  on  the 
basis  of  lowest  earnings  to  be  worth  80  per  cent  of  its 
par  value,  the  second-named  issue,  60  per  cent,  and  the 
third-named  issue,  60  per  cent:  It  would  then  offer 
to  the  bondholders  of  the  first  class  $800  in  new  general 
mortgage  bonds  for  each  $1,000  of  the  old  bonds,  and  to 
the  bondholders  of  the  second  and  third  classes,  $600 
in  the  new  bonds  for  $1,000  of  the  old  bonds.  As  the 
values  of  the  old  issues  and  the  amount  of  the  new  issue 
are  figured  on  the  same  basis,  lowest  net  earnings,  they 
must,  of  course,  exactly  correspond.  Not  every  case  is 
so  simple  by  any  means,  as  our  illustration.  The  same 
principle,  however,  would  always  be  applied. 

It  is  felt  to  be  equitable,  as  well  as  necessary  in  order 
to  satisfy  the  bondholders,  that  they  should  be  com- 
pensated for  the  reduction  of  their  interest-bearing 
principal.  This  is  accomplished  by  giving  them  at 
least  enough  dividend-paying  principal  to  bring  the  par 
value  of  their  holdings  in  the  reorganized  company  up 
to  an  equality  at  least — sometimes  considerably  more 
than  an  equality — with  the  par  value  of  their  old  secur- 


PRINCIPLES  OF  REORGANIZATION  42S 

ities.  Formerly  it  was  customary  to  give  them  the 
difference  between  the  par  value  of  their  old  bonds  and 
the  par  value  of  their  allotment  of  new  interest-bearing 
bonds  in  the  form  of  income  bonds.  Income  bonds 
have  abeady  been  described  and  characterized.  They 
are  a  fallacy  and  a  delusion  and  at  the  present  time  are 
practically  unused.  Their  place  in  reorganization  has 
now  been  taken  by  preferred  stock.  The  debenture 
bondholder  in  our  jUustration  who  got  $600  in  new  bonds 
forjl,000  in  old  bonds  wouldjander  the  present  practice 
probably  get  also  at  least  $400  in  preferred  stock.  He 
thusTiasarchance  to  shareTn  the  future  prosperity  of  the 
company.  He  may  well  hope  and  even  expect  that  in 
the  end  he  will  more  than  recover  his  losses.  The  same 
principle  is  applied  to  all  the  other  bondholders,  so  far 
as  practicable,  and  even  to  the  preferred  and  common 
stockholders.  It  follows  that  one  usual  and  almost 
necessary  result  of  a  reorganization  is  a  great  increase 
in  capitalization.  The  reorganization  committee  en* 
deavors  to  remedy  the  failures  and  disappointments  of 
the  past  and  present  by  drawing  heavy  drafts  on  the 
future.  It  is  only  fair  to  say  that  in  this  country  these 
drafts  have  usually  sooner  or  later  been  honored. 

The  final  problem  which  the  reorganization  committee 
must  settle  is  whether  to  revive  the  old  company  and  the 
old  charter  or  to  take  out  anew  charter  and  organize  a 
new  company.  The  first  course  involves  a  maintenance 
of  all  the  previously  existing  contracts  and  obligations 
of  the  company  not  provided  for  in  the  reorganization 
scheme.  Its  advantage,  of  course,  lies  in  the  retention 
of  the  charter  which  may  perhaps  confer  valuable 
privileges.  The  question  is  at  bottom  legal  rather  than 
financial.  In  truth,  it  is  a  matter  usually  of  no  very 
great  consequence. 


424»  CORPORATION  FINANCE 

To  insure  stability  of  financial  management,  until 
after  the  reorganized  company  is  well  started,  it  is  not 
uncommon  to  place  the  new  stock  in  the  hands  of  a  vot- 
ing trust  for  a  period  of  years.  The  nature  and 
operations  of  such  a  trust  have  already  been  described. 

243.  Summary  of  the  chapter, — Briefly  the  principles 
and  the  results  of  reorganization  may  be  summed  up  as 
follows : 
^  (a)  The  reorganization  must  remove  the  immediate 
causes  of  bankruptcy  by  providing  cash  and  at  the  same 
time  reducing  fixed  charges. 

,  (b)  The  reduction  of  securities  bearing  fixed  charges 
may  well  be  and  usually  is  accomplished  by  a  great 
increase  of  dividend-paying  securities. 

(c)  In  determining  who  shall  stand  the  losses  caused 
by  the  company's  insolvency,  the  reorganization  com- 
mittee will  first  rank  the  securities  in  the  order  of  their 
safety  and  will  then  impose  the  losses  in  inverse  order. 

(d)  In  so  doing  the  directors  must  of  necessity  con- 
sider primarily  the  ability  of  the  security-holders  to 
make  trouble  for  or  to  wreck  the  reorganized  company 
if  their  demands  are  not  satisfied. 

(e)  In  raising  necessary  cash  they  will  naturally  im- 
pose the  first  and  heaviest  assessments  on  stockholders, 
but  they  must  bear  in  mind  that  if  they  go  beyond 
certain  limits  the  stockholders  will  forfeit  their  shares 
rather  than  pay  the  assessments. 

The  working  out  of  these  principles  will  be  further 
discussed  in  connection  with  the  illustrations  cited  in  the 
following  chapter. 


A 


CHAPTER  XXX5 

THREE  TYPICAL  REORGANIZATIONS 

244.  Growth  of  the  Santa  Fe  System, — The  prin- 
ciples of  reorganization  laid  down  in  the  preceding 
chapter  will  be  much  better  understood  if  we  consider 
their  application  in  a  few  typical  instances.  For  this 
purpose  we  will  take,  first,  the  forced  reorganization  of 
the  insolvent  Atchison,  Topeka  and  Santa  Fe  Railroad 
Company  in  1894;  second,  the  voluntary  reorganization 
of  the  prosperous  Chicago,  Rock  Island  and  Pacific 
Railway  Company  in  1902;  third,  the  forced  reorganiza- 
tion of  the  Westinghouse  Electric  Manufacturing 
Company  in  1908. 

It  is  necessary  to  go  back  several  years  in  order  to  get 
a  typical  case  of  a  large  railroad  receivership  and  re- 
organization, for  American  railroads  in  the  last  twelve 
years  have  enjoyed  extraordinary,  and  up  to  1907 
almost  uninterrupted,  prosperity.  It  is  true  that  a 
considerable  number  of  railroad  systems,  including  the 
Seaboard  Air  Line,  the  Chicago,  Great  Western,  the 
Detroit,  Toledo  and  Ironton,  the  Chicago,  Cincinnati 
and  Louisville,  the  International  and  Great  Western, 
the  Western  Maryland  and  the  Macon  and  Birmingham 
went  into  the  hands  of  receivers  as  the  result  of  the  fi- 
nancial panic  of  October,  1907.  None  of  these  roads, 
however,  is  of  first-rate  importance  and  their  problems 
have  not  proved  as  intricate  and  difficult  as  the  problems 
of  the  numerous  railroad  reorganizations  following  the 
great  crisis  of  1893.     We  shall  find  it  therefore  more 

425 


426  CORPORATION  FINANCE 

instructive — even  if  not  of  so  great  current  interest — 
to  study  one  of  the  1893  reorganizations  rather  than 
one  of  later  date.^ 

Like  most  of  our  great  railroad  systems,  the  Atchi- 
son, Topeka  and  Santa  Fe  has  grown  by  leaps,  so  to 
speak.  It  was  chartered  in  Kansas  in  the  year  1863, 
and  contruction  on  the  first  section  of  the  road  was 
begun  in  1869.  The  main  line  from  Kansas  City  to 
Colorado,  thence  in  a  southerly  direction  to  Albuquer- 
que, New  Mexico,  and  thence  southwest  to  a  con- 
nection with  the  Southern  Pacific  Railroad  at  Deming, 
Arizona,  was  not  completed  until  1881.  In  1882  the 
Atchison  exchanged  its  stock  for  the  stock  of  the  Sonora 
Railroad,  and  thus  secured  an  entrance  to  Guaymas, 
Mexico.  The  company  by  using  a  section  of  the  track 
of  the  Southern  Pacific  had  a  through  route  from 
Kansas  City  to  the  Pacific  Coast.  To  appreciate  the 
importance  of  reaching  the  Pacific  Ocean  it  must  be 
borne  in  mind  that  traffic  from  any  of  the  Pacific  Coast 
ports  may  move  readily  and  cheaply  by  water  to  any 
other  of  these  ports.  The  Santa  Fe  was  therefore  in 
a  position  to  take  through  business  by  its  part-water- 
and-part-rail  route  from  any  port  on  the  Pacific  Coast 
to  the  East. 

This  route,  though  important,  could  not,  however, 
bring  to  the  Santa  Fe  a  large  proportion  of  the  traffic  to 
and  from  the  Pacific  Coast  in  the  face  of  the  existing 
competition  of  the  all-rail  routes,  particularly  of  the 
Santa  Fe's  chief  competitor,  the  Southern  Pacific. 
President  Strong  of  the  Santa  Fe  therefore  entered  into 

1  Acknowledgment  should  be  made  here,  in  connection  with  the  following 

i  reviews  of  the  Santa  Fe  and  Rock  Island  reorganizations,  of  the  informa- 
tion obtained  from^Mr.  Stuart  Daggetfs  "  Railroad  Re-Organization."  Most 
of  what  follows  as^  to  these  two  companies  is  based  on  Mr.  Daggett's  re- 
searches. He  is  one  of  the  first  to  bring  to  bear  on  financial  problems  the 
thorough,  scientific  methods  of  university  scholarship. 


J 


TYPICAL  REORGANIZATIONS  427 

an  alliance  with  the  St.  Louis  and  San  Francisco  Rail- 
road, which  owned  the  charter  of  a  company  known  as 
the  Atlantic  and  Pacific  Railroad  Company.  By  the 
terms  of  this  alliance  the  two  roads  jointly  financed  the 
operations  of  the  Atlantic  and  Pacific  and  by  means 
of  purchase  and  of  new  construction  endeavored  to 
secure  a  through  rail  route  to  San  Francisco.  In 
1885 — one  of  the  great  railroad  building  years  of  the 
United  States — ^the  Atchison,  by  construction,  purchase 
and  lease  combined,  managed  to  reach  Los  Angeles. 
The  main  line  of  the  road  still  had  its  eastern  terminal, 
however,  at  Kansas  City  and  the  system  did  not  reach 
the  Gulf  of  Mexico,  or  in  fact  any  of  the  rapidly 
developing  agricultural  country  south  of  Kansas.  To 
remedy  this  defect  a  road,  known  as  the  Gulf,  Colorado 
and  Santa  Fe,  had  been  constructed,  partly  in  the 
interest  of  the  Santa  Fe,  from  Galveston  to  a  point 
about  two  hundred  miles  north,  and  another  line  known 
as  the  Southern  Kansas  Railroad  was  built  south  from 
Arkansas  City  to  connect  with  the  track  of  the  Gulf, 
Colorado  and  Santa  Fe.  In  1886  the  stock  of  the  last- 
named  road  was  bought  by  the  Atchison  and  the  bonds, 
to  the  extent  of  about  $17,000  per  mile,  were  assumed. 
In  1887  the  Atchison  purchased  the  Chicago  and  St. 
I^ouis  Railroad  between  Chicago  and  Streator,  Illinois, 
and  other  subsidiary  companies  constructed  new  track 
up  to  Streator.  By  1888  it  had  thus  obtained  its 
Chicago  entrance. 

In  the  meantime  between  '86  and  '89  it  had  built  a 
large  number  of  branch  lines  in  all  directions  largely 
for  the  purpose  of  forestalling  competition.  "The 
method  of  financing  these  competitive  extensions 
varied,"  says  Mr.  Daggett.  "Sometimes  the  parent 
company  guaranteed  the  principal  and  interest  of  the 


42a  CORPORATION  FINANCE 

branch  line  bonds;  sometimes  it  took  these  into  its 
treasury  and  issued  collateral  bonds  against  them; 
sometimes,  perhaps  more  frequently  still,  it  leased  new- 
roads  for  a  rental  equivalent  to  the  annual  interest  on 
their  bonds.  If  the  branches  could  have  earned  their 
fixed  charges,  the  burden  of  the  Atchison  would  have 
been  nominal,  but  as  in  large  part  they  could  not,  it  was 
real  and  serious." 

The  results  of  the  rapid  expansion  of  the  Santa  Fe 
from  1884  to  1888  are  well  summarized  by  Mr.  Daggett 
in  the  following  table: 

ISSJt  1S88 

Mileage 2,799  7,010 

Bonds    $48,258,500  $163,694,000 

Stock    (Atchison)     ........      60,673,150  .75,000,000 

Gross  earnings   16,699,662'  28,265,339 

Operating  expenses .        9,410,424  21,958,195 

Net  earnings  from  operation       7,289,237  6,307,145 
Net    profits    excluding    divi- 
dends        5,147,883     def.         2,933,197 

Net  profits,  including  pay- 
ments for  dividends  and 
interest  on  floating  debt  .  def.         5,557,323 

It  should  be  noted  that  while  the  bond  indebtedness 
(including  the  assumed  bonds  of  subsidiary  companies) 
had  considerably  more  than  tripled,  gross  earnings  had 
increased  only  about  70  per  cent  and  net  earnings  from 
operation  had  declined.  Evidently,  unless  this  tendency 
should  be  speedily  reversed,  the  company  was  doomed 
to  insolvency.  In  addition  the  floating  debt  had  in- 
creased from  approximately  $3,300,000  in  1884  to  over 
$8,000,000  in  1888,  and  the  road  had  consequently  been 
forced  to  authorize,  in  October,  1888,  $10,000,000  of 
three-year  notes 


TYPICAL  REORGANIZATIONS  429 

245.  First  reorganization  of  the  Santa  Fe  and  its 
results, — The  situation  was  so  obviously  dangerous  that 
a  committee  of  the  directors  was  appointed  in  1889  to 
bring  about  a  friendly„reqr^ardzation^nd  ther^^ 
^;y^rt_bankruptcy. 

About  one-third  of  the  $163,000,000  of  bonds  were 
direct  obligations  secured  by  mortgages  on  the  Atchi- 
son's own  property,  while  the  other  two-thirds  con- 
sisted of  obligations  of  thirty-two  subsidiary  companies. 
From  what  has  been  said  in  the  preceding  chapter,  it 
will  be  seen  that  the  entanglements  and  conflicts  of  these 
various  issues  were  almost  beyond  unraveling.  The 
directors  first  aimed  at  simplification  and  with  that 
object  in  view  suggested  that  two  large  issues  be  put 
forth,  one  of  4  per  cent  general  mortgage  bonds,  to  the 
amount  of  $150,000,000,  and  one  of  5  per  cent  income 
bonds  to  a  total  of  $80,000,000.  Some  $14,000,000 
were  to  be  sold  in  order  to  raise  necessary  cash  and  the 
remainder  of  the  two  bond  issues  was  to  be  exchanged 
for  the  numerous  existing  issues.  Income  bonds  were 
much  used  in  reorganization  at  that  period  and  were  not 
received  with  the  distrust  which  they  now  excite.  The 
proposal  to  the  original  bondholders  that  they  should 
exchange  their  mortgage  bonds  in  part  for  income  bonds 
was  not,  of  course,  altogether  palatable;  yet  it  must 
be  remembered  that  the  bonds  which  were  to  be  thus 
exchanged  had  always  been  regarded  as  more  or  less 
speculative  in  character  and  had  for  that  reason  been 
sold,  for  the  most  part,  well  below  par,  and,  further- 
more, that  the  branch  line  bondholders  would  have  lost 
rather  than  gained  by  a  forced  bankruptcy  and  fore- 
closure sale.  Moreover,  the  basis  of  the  exchange  was 
such  as  to  compensate  them  in  part  for  their  loss  of  fixed 
interest   payments   by    a   larger    principal.     In    other 


430  CORPORATION  FINANCE 

words,  as  usually  happens  in  reorganizations,  the  com- 
pany proposed  to  cut  down  its  current  fixed  charges  and 
held  out  in  place  thereof  hopes  of  high  optional  pay- 
ments in  the  future.  The  reorganization  plan  was 
accepted  and  put  into  effect. 

After  this  reorganization,  the  Atchison  policy  of  rapid 
expansion  was  apparently  renewed  with  fresh  vigor. 
In  1890,  by  an  exchange  of  securities,  the  St.  Louis  and 
San  Francisco  Railroad  was  brought  into  the  Atchison 
system.  This  acquisition  of  1,300  miles  at  one  stroke 
did  not  prove  nearly  as  profitable  as  was  anticipated. 
In  the  same  year  the  Colorado  Midland,  346  miles  long, 
was  purchased. 

When  the  $10,000,000  note  issue  of  1888  fell  due 
in  1891,  the  directors  found  themselves  unable  to  meet 
the  payment  out  of  earnings  and  therefore  arranged 
for  a  two-year  extension.  In  1892  the  need  of  addi- 
tional funds  for  improvements  and  extensions,  which,  as 
the  reader  may  have  noted,  had  not  been  at  all  provided 
for  in  the  reorganization  of  1889,  made  necessary  a  new 
issue  of  second  mortgage  bonds.  As  the  terms  of  issue  of 
the  $80,000,000  income  bonds  forbade  any  prior  lien  (ex- 
cept the  first  mortgage)  being  placed  upon  the  property, 
it  was  necessary  before  placing  a  second  mortgage  to 
arrange  for  the  protection  of  the  income  bondholders. 
This  was  accomplished  by  making  the  second  mortgage 
cover  an  issue  of  $100,000,000  4  per  cent  bonds, 
$80,000,000  of  which  were  to  be  exchanged  doUar-for- 
doUar  for  the  income  bonds,  and  $20,000,000  to  be 
sold  for  cash.  Thus  in  1893,  by  a  coincidence,  which 
may  be  called  unfortunate,  but  which  with  wise  manage- 
ment would  never  have  occurred,  the  Atchison  had  to 
face  largely  increased  fixed  charges  and  the  payment  of 
the  $10,000,000  note  issue,  both  coming  at  the  same  time 


J 


TYPICAL  REORGANIZATIONS  431 

with  the  panic  and  the  traffic  losses  of  that  disastrous 
year.  In  January,  1894.,  the  inevitable  insolvency 
arrived. 

246.  Second  reorganization  and  its  results. — Several 
bondholders'  committees,  according  to  the  custom  in  re- 
organization, were  quickly  formed.  Among  others  the 
English  holders  of  second-mortgage  bonds  sent  over  a 
strong  committee  which  put  forward  what  was  known 
as  the  English  plan  of  reorganization. 

This  plan  involved  foreclosure  either  by  the  first  or 
second  mortgage  bondholders.  In  either  case  the  first 
mortgage  issue  would  be  left  undisturbed  and  overdue 
interest  would  be  paid  either  in  cash  or  in  new  securities. 
A  new  income  mortgage  bond  issue  was  to  be  exchanged 
for  the  second  mortgage  bonds  and  was  also  to  provide 
compensation  for  an  assessment  of  $12  per  share  on  the 
stockholders.  By  paying  this  assessment  the  stock- 
holders would  retain  their  stock  interest  in  the  road,  as 
well  as  receive  income  bonds.  The  income  bonds  were 
to  have  voting  power.  The  substance  of  the  plan,  it 
is  evident,  was  to  reverse  the  former  conversion  of  in- 
come bonds  into  second  mortgage  bonds.  In  the  re- 
conversion the  English  bondholders  were  to  secure  an 
increase  in  principal  and  the  important  privilege  of 
voting.  The  plan  was  not  acceptable  to  the  stock- 
holders, however,  who  felt  that  part  of  the  load  thus 
imposed  upon  them  ought  rightfully  to  be  borne  by  the 
second  mortgage  bondholders. 

Before  the  argument  had  been  carried  far  a  new  factor 
was  introduced  into  the  situation,  namely,  the  publica- 
tion of  the  report  of  Mr.  Stephen  Little,  an  expert  ac- 
countant who  had  thoroughly  investigated  the  Atchison 
books.  Mr.  Little  found  that  by  means  of  peculiar  fic- 
titious accounts — most  important  of  which  was  an  ac- 


43a  CORPORATION  FINANCE 

count  that  carried  rebates  by  the  company  as  an  asset — 
the  recorded  earnings  of  the  railroad  had  been  dehber- 
ately  inflated.  The  annual  net  earnings,  according  to 
the  company's  reports,  had  been  as  follows : 

1891    . ., $  7,631,598 

189^ 10,953,896 

1893    12,126,866 

According  to  Mr.  Little  they  should  have  been : 

1891 $  5,204,880 

1892    ,. .       7,853,173 

11893 8,085,608 

1894? 5,956,615 

This  startling  announcement  completely  changed 
the  plans  which  had  been  formulated.  It  was  evident 
that  a  far  more  radical  reduction  of  fixed  charges  would 
be  essential. 

A  new  committee  proposed  the  second  and  final  re- 
organization plan  in  March,  1895.  The  purposes  of  this 
plan  were  stated  to  be: 

(a)  To  reduce  fixed  charges  to  a  safe  limit; 

(b)  To  provide  for  future  capital  requirements; 

(c)  To  liquidate  the  floating  debt; 

(d)  To  reinstate  existing  securities  upon  equitable 
terms  in  the  order  of  their  priority; 

(e)  To  consolidate  and  unify  the  system. 

The  committee  proposed  foreclosure  under  the  first 
mortgage  and  the  formation  of  a  new  railway  company 
which  was  to  issue 

(a)  Common  stock $102,000,000 

(b)  5  per  cent  non-cumulative  preferred 

stock    $111,486,000 


TYPICAX.  REORGANIZATIONS  433 


^(c)   General  4  per  cent  bonds $96,990,582 

'(d)   Adjustment '  4  per  cent  bonds $51,728,310 

Old  common  stockholders  were  to  receive  share  for 
share  new  common  stock  provided  they  paid  an  assess- 
ment of  $10  per  share  and  for  this  $10  were  to  receive 
$10  in  new  preferred  stock.  An  underwriting  syndicate 
guaranteed  to  take  the  place  of  defaulting  stockholders. 
iThe  old  general  mortgage  bondholders  were  given  75 
per  cent  of  their  holdings  in  new  general  mortgage 
bonds  and  40  per  cent  in  adjustment  bonds.  The 
second-mortgage  bondholders  were  to  be  assessed  $4  for 
every  $100  of  their  holdings  and  were  to  receive  113  per 
cent  in  new  preferred  stock.  It  was  provided  that  ad- 
ditional bonds  under  the  general  mortgage  might  be  is- 
sued at  the  rate  of  $3,000,000  per  year  up  to  a  limit  of 
$30,000,000  and  that  thereafter  additional  adjustment 
bonds  might  be  issued  at  the  rate  of  $2,000,000  per  year 
up  to  a  limit  of  $20,000,000. 

The  St.  Louis  and  San  Francisco  Railroad  and  some 
other  smaller  subsidiary  lines  were  not  included  in  the 
reorganization  plan,  but  were  turned  over  to  their  own 
bondholders. 

It  will  be  seen  that  this  plan  accomplished  the  five 
purposes  named  by  the  conmiittee.  It  brought  about 
a  very  radical  reduction  of  fixed  charges  affecting  even 
the  first  mortgage  bondholders.  It  gave  room  for  ad- 
ditional issues  of  bonds  under  certain  restrictions  to 
provide  for  future  improvements  and  extensions.  It 
brought  in  about  $14,000,000  cash  to  meet  current  ob- 
ligations. It  retained  the  relative  claims  of  the  various 
security-holders  to  the  road's  assets  and  earnings.  Fi- 
nally, by  lopping  off  nonessential  lines,  it  helped  to  con- 
solidate and  unify  the  system. 

1  The  so  called  adjustment  bonds  were  in  reality  income  bonds. 

1—28 


434  CORPORATION  FINANCE 

The  principal  opposition  to  the  plan  came  from  some 
of  the  minority  stockholders  who  believed  that  the  former 
management  had  proved  untrue  to  their  interests  and 
that  this  management  had  not  been  entirely  eliminated. 
This  opposition,  however,  was  unable  to  muster  enough 
votes  to  defeat  the  reorganization  plan. 

The  high  credit  and  prosperity  of  the  Atchison  in  the 
last  few  years  indicates  that  the  reorganization  was  car- 
ried through  on  sound  lines.  There  has  never  been  a 
question  raised  since  the  reorganization  but  that  the  com- 
pany could  easily  meet  all  its  obligations.  The  road  has 
been  greatly  improved  and  strengthened  physically  and 
earnings  have  grown  far  more  rapidly  than  expenses. 
The  changes  since  1897  are  shown  in  the  following 
tabulation: 

1897  1907 

Mileage     6,479  9,273 

Gross   earnings ,  $30,621,230         $93,683,407 

Net  earnings . 7,754,041  32,153,692 

Annual  surplus 1,452,446  21,168,724 

Naturally  the  market  price  of  the  Atchison  securi- 
ties has  steadily  risen.  Nobody  suffered  in  the  end  from 
the  reorganization.  On  the  contrary,  all  the  security- 
holders who  retained  their  interests  have  seen  them 
steadily  appreciate  in  value.  The  Atchison  reorgan- 
ization of  1895  may  well  be  taken  as  a  fair  type  of  a 
highly  successful  readjustment  of  charges. 

247.  Growth  of  the  Rock  Island  System. — We  will 
consider  now  an  entirely  different  kind  of  reorganization 
— one  in  which  not  necessity  but  desire  for  quick  specu- 
lative profits  was  the  controlling  factor.  In  order  to 
understand  the  situation  it  will  be  well  to  review  hastily 
the  history  of  the  Rock  Island  Railroad.  The  line  was 
completed  between  Chicago  and  Rock  Island  in  1854, 


TYPICAL  REORGANIZATIONS  435 

and  from  Rock  Island  to  Council  Bluffs  in  1869.  The 
company  was  prosperous  almost  from  the  beginning. 
Its  road  ran  through  a  well-settled  and  fertile  territory 
where  traffic  was  large  and  certain  and  construction  was 
cheap.  Capitalization  was  very  moderate,  especially  as 
compared  with  many  other  western  railroads  whose  con- 
struction was  paid  for  not  in  cash  but  in  extravagant 
allotments  of  stocks  and  bonds  to  the  contractors.  In 
1880  the  road  was  earning  so  much  and  paying  such 
large  dividends  that  it  seemed  desirable  to  water  the 
stock.  This  was  accomplished  by  an  exchange  of  the 
stock  of  the  Chicago,  Rock  Island  and  Pacific  Railroad 
Company  for  the  stock  of  a  new  Chicago,  Rock  Island 
and  Pacific  Railway  Company  in  the  ratio  of  about  two 
to  one.  The  new  Railway  Company  also  took  in  some 
other  properties  previously  controlled  by  the  Railroad 
Company,  and  was,  therefore,  in  form,  though  not  in 
fact,  a  consolidation. 

The  new  railway  company  did  not  continue  to  be  as 
prosperous  as  it  was  in  the  beginning.  The  middle  '80s 
were  hard  years  for  western  railroads,  for  all  of  them 
were  forced  into  competitive  railroad  building,  which  for 
the  time  being  was  largely  unprofitable.  The  Rock  Is- 
land dividends  and  the  market  prices  of  the  road's  se- 
curities suffered  severely.  Nevertheless,  the  road's  man- 
agement was  conservative  and  able  and  the  company  not 
only  survived,  but  even  paid  dividends  through  the  try- 
ing depression  of  1893-1897.  After  1897  the  road 
shared  in  the  renewed  prosperity  of  the  United  States 
and  began  in  its  conservative  way  to  plan  for  further 
expansion  and  development. 

In  1901,  however,  the  conservatism  of  the  company: 
suddenly  disappeared  as  if  the  earth  had  swallowed  it. 
Directors  and  officers  who  had  served  for  years  and  dec- 


436  CORPORATION  FINANCE 

ades  were  removed,  and  new  men — younger  men  of  an 
entirely  different  type — were  put  into  their  place. 
iWith  the  older  men  there  vanished  also  the  former  ideals 
and  purposes  of  the  company  and  a  very  different  path 
[toward  success  and  prosperity  was  entered. 

The  reason  for  these  changes  is  to  be  found  in  the  fact 
that  during  1900  and  1901  a  small  coterie  of  speculative 
promoters  known  as  "the  Moore  crowd,"  of  whom  we 
have  heard  in  connection  with  the  formation  of  the 
United  States  Steel  Corporation,  had  quietly  bought  a 
majority  of  the  common  stock  in  the  Wall  Street 
market.  The  process  of  buying  had  been  carried  on  so 
patiently  and  warily  that  it  was  hardly  suspected  and 
the  price  of  the  stock  was  very  little  increased.  The 
financial  world  first  got  an  inkling  of  the  situation  when 
in  April,  1901,  Mr.  Wilham  H.  Moore  and  Mr.  D.  G. 
iReid  were  elected  to  the  directorate. 

The  principal  men  in  the  new  party,  which  now  rap- 
idly assumed  full  control  of  Rock  Island  affairs, 
were  Mr.  W.  H.  Moore,  his  brother  Mr.  J.  H.  Moore, 
Mr.  D.  G.  Reid  and  Mr.  William  B.  Leeds.  No  one 
of  these  men  had  had  any  experience  in  railroad  man- 
agerial positions  and  none  of  them  had  ever  been  prom- 
inently identified  before  with  railroad  operations.  All 
of  them,  however,  were  bold  and  successful  speculative 
promoters  and  all  of  them  were  well  versed  in  the  ways 
and  wiles  of  the  speculative  security  market.  Their 
successes  had  been  gained  in  the  promotion  of  the  com- 
panies which  were  taken  into  the  United  States  Steel 
Corporation.  Their  interest  in  railroad  affairs,  there- 
fore, it  was  easy  to  see,  was  entirely  financial.  They 
did  not  take,  and  as  a  matter  of  fact  never  have  taken, 
any  active  part  in  the  operating  management  of  their 
road.     All  their  energies  have  been  given  to  maintain- 


TYPICAJ.  REORGANIZATIONS  437 

ing  its  financial  status  and  at  the  same  time  directing  for 
their  own  benefit  its  financial  operations. 

In  the  two  annual  meetings  of  June,  1901,  and  June, 
1902,  the  stockholders  increased  their  capital  stock  from 
$50,000,000,  at  which  it  had  been  placed  in  1880,  to 
$75,000,000.  Also  the  stock  of  some  smaller  roads,  in- 
cluding the  important  Choctaw,  Oklahoma  and  Gulf, 
was  bought  by  the  Rock  Island,  payment  being 
made  partly  in  cash  and  partly  in  Rock  Island  secu- 
rities. 

248.  Rock  Island  reorganization. — The  "Moore 
crowd"  now  brought  forward  the  scheme  of  reorganiza- 
tion which  they  had  devised  primarily,  it  appears,  with 
a  view  to  selling  a  large  part  of  their  stock  without  los- 
ing control.  The  plan  involved  two  holding  companies 
and  a  double  exchange  of  securities.  It  is  perhaps  the 
most  complex  and  ingenious  scheme  on  a  large  scale  for 
attaining  the  purpose  just  named  that  has  yet  been  suc- 
cessfully put  through. 

The  operating  company  under  this  scheme  remained 
the  same  as  it  had  been  since  1880,  the  Chicago,  Rock 
Island  and  Pacific  Railway  Company.  The  first  hold- 
ing company  (whose  prime  object,  apparently,  was  to 
meet  any  legal  objection  that  might  afterwards  arise  to 
the  consolidation  of  competing  railway  companies)  was 
the  Chicago,  Rock  Island  and  Pacific  Railroad  Com- 
pany, incorporated  in  Iowa.  The  second  holding  com- 
pany was  the  Rock  Island  Company,  incorporated  in 
New  Jersey.  The  outstanding  bonds  and  other  secu- 
rities of  the  old  "railway"  company  were  left  undis- 
turbed. The  new  "railroad"  company  issued  stock  to 
the  amount  of  $75,000,000.  The  Rock  Island  Company 
issued  $96,000,000  common  and  $54,000,000  preferred 
stock.     The  last-named  company  then  deUvered  $127,- 


438  CORPORATION  FINANCE 

500,000  of  its  preferred  and  common  stock  to  the  Chi- 
cago, Rock  Island  and  Pacific  Railroad  Company  of 
Iowa  in  exchange  for  all  the  $125,000,000  common  stock 
of  the  Iowa  company.  After  this  transaction  the  last- 
named  company  had  in  its  treasury  most  of  the  common 
and  preferred  stock  of  the  Rock  Island  Company ;  it  also 
had  the  right  to  issue  $75,000,000  bonds.  It  now  of- 
fered for  each  share  of  the  railway  company's  stock,  one 
share  of  its  own  4  per  cent  bonds,  one  share  of  Rock 
Island  Company  common  stock  and  $70  of  Rock  Island 
Company  preferred  stock.  These  bonds  were  to  be  col- 
lateral trust  secured  by  the  deposit  of  all  the  "railway" 
company  shares  obtained  by  the  "railroad"  company. 
Thus  the  "railway"  stockholders  would,  in  case  of  de- 
fault, get  back  exactly  the  stock  which  they  had  ex- 
changed. 

The  "railway"  stockholders  readily  accepted  this  prop- 
osition, which  was  equivalent  to  giving  a  large  stock  div- 
idend, and  figured  that  even  if  they  retained  in  their  own 
hands  all  the  securities  which  they  received  in  exchange 
they  could  not  lose  and  might  benefit  by  the  exchange. 
If  they  did  not  care  to  retain  all  the  securities  they  re- 
ceived, they  could  easily  dispose  of  their  Rock  Island 
common  and  preferred  shares  and  thus  get  a  large  im- 
mediate cash  payment. 

We  shall  understand  better  why  the  "Moore  crowd" 
desired  this  reorganization  if  we  examine  the  charter 
provisions  of  the  Rock  Island  Company.  One  of  the 
important  clauses  reads  as  follows: 

There  shall  be  five  classes  of  directors.  The  first  class  shall 
contain  a  majority  of  the  whole  number  of  the  directors  as  fixed 
at  any  time  by  the  by-laws.  The  holders  of  the  preferred  stock 
shall  have  the  right  to  the  exclusion  of  the  holders  of  the  com- 
mon stock  to  chose  directors  of  the  first  class. 


TYPICAL  REORGANIZATIONS  439 

Thus  a  majority  of  the  Rock  Island  Company  preferred 
stock  could  elect  a  majority  of  the  board  of  directors  of 
that  company  and  this  board,  through  the  company's 
holdings  of  "railroad"  stock  could  completely  control  all 
the  affairs  of  the  Chicago,  Rock  Island  and  Pacific 
Railway  Company,  the  operating  company.  Now  the 
outstanding  preferred  stock  of  the  Rock  Island  Com- 
pany is  only  a  little  over  $45,000,000;  therefore  the 
ownership  of  approximately  $22,500,000  par  value  of 
this  preferred  stock  would  be  sufficient  to  give  complete 
control  over  the  whole  Chicago,  Rock  Island  and  Pa- 
cific Railway  Company,  having  a  total  capitalization  of 
about  $225,000,000.  Indeed,  if  this  $22,500,000  pre- 
ferred stock  were  carried  on  a  margin  of  $20  a  share, 
$5,400,000  cash  would  suffice  to  secure  control. 

The  advantage  of  this  reorganization  to  the  "Moore 
crowd"  may  readily  be  seen  if  we  compare  the  price  they 
paid  for  control  in  the  "railway"  company  with  what  is 
necessary  for  control  in  the  Rock  Island  Company. 
Assuming  that  they  bought  all  their  stock  outright  and 
paid  in  the  neighborhood  of  140,  which  was  not  far  from 
the  average  market  price  while  they  were  buying  control 
of  the  "railway"  company,  their  investment  would  have 
been  $52,500,140.  In  exchange  for  this  under  the  re- 
organization scheme  they  obtained  stock  and  bonds  which 
at  the  market  prices  of  the  early  part  of  1903  were 
worth : 

Rock  Island  Company  common $18,375,049  ' 

Rock  Island  Company  preferred 21,918,808 

Chicago,  Rock  Island  &  Pacific  Railroad  Co. 

4%  bonds 32,765,712 

Total     $73,059,569 


440  CORPORATION  FINANCE 

As  the  preferred  stock  was  all  that  was  necessary  for 
control  they  were  left  free  to  sell  their  bonds  and  com- 
mon stock,  and  it  will  be  observed  that  this  sale  would 
have  brought  to  them  just  about  as  much  cash  as  they 
had  originally  paid  for  control  of  the  Chicago  Rock 
Island  and  Pacific  Railway  Company.  In  other  words, 
control  of  the  Rock  Island  Company,  carrying  with  it 
control  of  both  subsidiary  companies,  cost  them  in  cash 
next  to  nothing. 

In  addition,  the  Rock  Island  Company  later  obtained 
control  of  another  great  railroad  system,  the  St.  Louis 
and  San  Francisco.  The  Rock  Island  directors  ac- 
complished this  by  offering  to  exchange  for  each  share 
of  common  stock  of  the  St.  Louis  and  San  Francisco 
$60  par  value  in  the  common  stock  of  the  Rock  Island 
Company  and  $60  par  value  in  a  new  issue  of  5  per  cent 
gold  bonds,  the  bonds  being  secured  by  deposit  of  the 
"Frisco"  common  stock  as  collateral.  It  will  be  ob- 
served that  this  great  addition  to  the  Rock  Island  system 
did  not  disturb  in  any  way  the  controlling  force  of  a 
majority  of  the  relatively  small  issue  of  Rock  Island 
Company  preferred  stock.  Thus  by  reorganization  and 
purchase  the  "Moore  crowd"  with  a  very  small  expendi- 
ture of  cash,  have  under  their  control  a  system  with  an 
aggregate  mileage  of  14,270  miles. 

249.  Westinghouse  reorganization, — This  recent  re- 
organization, although  not  essentially  different  in  prin- 
cij)le  from  the  Santa  Fe  reorganization,  introduces  some 
new  features  that  are  worthy  of  attention.  Owing  to 
space  limits  it  is  necessary  to  confine  our  attention  to 
these  peculiar  features. 

This  is  a  typical  instance  of  a  company  which  was 
strong  in  equipment  and  ability  and  which  was  doing  a 


TYPICAL  REORGANIZATIONS  441 

large  and  profitable  business  and  yet  suddenly  found 
itself  technically  insolvent.  Its  difficulties  resulted 
from  a  lack  of  sufficient  working  capital.  The  com- 
pany's assets  were  too  largely  fixed,  and  quick  assets 
were  relatively  too  small,  considering  the  amount  and 
character  of  the  company's  business.  In  prosperous 
times  the  company  was  able  to  prosper  with  the  rest  of 
the  country.  In  the  period  of  strain,  however,  it  was 
very  quickly  stripped  of  cash  and,  being  unable  to  ob- 
tain capital,  necessarily  went  to  the  wall. 

It  naturally  followed  that  the  most  active  and  influ- 
ential body  of  creditors  in  planning  the  reorganization 
were  merchandise  creditors ;  next  to  them  came  the  bank 
creditors ;  the  bond  and  note  holders  were  little  consulted 
and  their  claims  were  not  disturbed. 

The  problem  before  the  reorganizers  of  this  company 
differed  from  that  which  confronts  most  reorganizers 
in  that  the  company  needed  simply  to  be  tided  over  a  bad 
period.  No  one  apparently  felt  any  question  as  to  the 
renewed  prosperity  of  the  company  as  soon  as  normal 
business  conditions  should  be  restored.  The  permanent 
fixed  charges  were  met  even  during  the  period  of  re- 
organization. All  that  was  necessary,  therefore,  was  to 
take  care  of  the  floating  debt. 

The  main  elements  in  the  floating  debt  were  notes 
payable  to  banks,  $7,919,000,  and  merchandise  debts, 
$4,762,000.  After  much  discussion  and  consideration 
of  two  or  three  plans,  the  merchandise  creditors,  through 
their  committee,  finally  agreed  to  accept  new  common 
stock  of  the  company  at  par  in  full  settlement  of  their 
claims  on  certain  conditions  specified  below: 

(a)  Such  of  the  bank  debt  as  would  not  accept  new 
common  stock  to  be  provided  for  partly  by  convertible 
bonds  of  an  issue  already  authorized  previous  to  the 


442  CORPORATION  FINANCE 

bankruptcy  and  partly  by  5  per  cent  notes  running  for 
an  average  period  of  5  years. 

(b)  The  existing  issues  of  convertible  bonds,  deben- 
ture certificates  and  collateral  notes  not  to  be  disturbed. 

(c)  The  preferred  and  common  stockholders  each  to 
pay  a  25  per  cent  assessment  in  cash. 

It  will  be  observed  that  none  of  the  sacrifices  under 
this  plan  were  to  be  made  by  the  bond  and  note  holders. 
Indeed,  it  would  have  been  impossible  to  impose  sacri- 
fices upon  these  classes  or  to  refuse  or  modify  their 
claims,  for  in  that  case  they  would  certainly  have  been 
prompt  to  bring  foreclosure  proceedings,  buy  the  prop- 
erty at  a  forced  sale  and  thus  reduce  the  unsecured 
claims  and  wipe  out  the  stockholders.  The  bond  and 
note  holders,  in  other  words,  were  in  an  impregnable 
position  because  the  company,  even  in  the  worst 
times,  was  more  than  earning  the  permanent  fixed 
charges. 

The  bank  creditors  came  next  in  order  of  preference, 
and  their  only  loss,  therefore,  was  an  extension  of  time 
of  payment  of  their  obligations.  The  unsecured  credit- 
ors, knowing  the  weakness  of  their  position,  were  willing 
to  accept  stock  in  payment.  Under  the  circumstances 
it  was  both  expedient  and  just  that  the  stockholders 
should  be  called  on  for  a  particularly  heavy  assessment. 
It  was  expedient  because  the  prospects  of  the  company 
were  excellent  and  the  stock,  even  through  the  reorgan- 
ization, sold  at  fairly  good  prices.  The  stockholders, 
therefore,  could  well  aif ord  to  pay  this  assessment  rather 
than  forfeit  the  stock.  It  was  just  that  they  should  pay 
because  the  difficulties  of  the  company  could  have  been 
prevented  if  less  had  been  paid  out  in  dividends  and 
more  cash  had  been  reserved  for  an  emergency.  Such 
protests  as  were  made  by  the  stockholders  for  these 


TYPICAL  REORGANIZATIONS  443 

reasons  proved  unavailing  and  the  plan  as  outlined  above 
has  been  carried  into  effect. 

Just  how  successful  the  company  will  be  under  this 
plan  remains  to  be  seen.  There  is  no  reason,  however, 
to  fear  the  result.  The  plan  has  provided  for  all  the 
floating  debt  incurred  before  the  reorganization,  has  en- 
larged only  very  slightly  the  fixed  charges  of  the  com- 
pany, and  has  introduced  new  and  conservative  elements 
into  the  management  of  the  company.  The  cash  work- 
ing capital  on  hand  is  estimated  to  be  amply  sufficient 
for  the  needs  of  the  next  two  years,  even  if  business 
should  be  very  poor  indeed.  In  addition  it  has  been 
recently  stated  on  good  authority  that  dividends  on  the 
new  common  stock  of  the  company  will  not  be  paid  for 
at  least  two  years,  thus  giving  time  for  the  accumula- 
tion of  a  substantial  surplus.  The  readers  of  this  book 
are  urged  to  watch  closely  the  future  course  of  the 
Westinghouse  Electric  and  Manufacturing  Company, 
and  to  note  for  themselves  whether  the  opinions  here 
expressed  are  confirmed  or  not  by  the  company's  ex- 
perience. 


QUIZ  QUESTIONS 

{The  numbers  refer  to  the  numbered  sections  in  the 

text.) 

CHAPTER  I 

1.  What  are  "non-stock"  corporations? 

2.  What  are  "stock"  corporations?  For  what  pur- 
pose are  they  usually  organized? 

3.  What  is  the  most  striking  distinctive  feature  of 
the  corporation  compared  to  other  forms  of  business 
association? 

4.  In  what  sense  is  "corporate  entity"  a  fiction? 

5.  In  what  nations  have  corporations  been  prominent 
features  of  business  life? 

6.  Show  briefly  how  the  use  of  corporations  has 
spread  in  recent  years. 

7.  State  how  and  why  the  corporate  form  is  well 
adapted  to  raising  large  amounts  of  capital. 

8.  In  what  sense  is  a  corporation  more  permanent 
than  a  partnership  or  than  individual  proprietorship? 
How  is  this  attribute  an  advantage? 

9.  Show  how  and  why  the  corporate  form  better 
lends  itself  to  an  efficient,  centralized  control  of  a  bus- 
iness than  the  partnership  form. 

10.  Can  an  interest  in  a  corporation  be  more  readily 
transferred  from  one  person  to  another  than  an  interest 
in  a  partnership?    Why? 

445 


446  CORPORATION  FINANCE 

11.  What  is  the  principle  of  limited  liability  of  cor- 
porate stockholders?  Is  the  principle  universally  ap- 
plicable? Name  the  principal  advantages  of  the 
corporate  form  of  organization. 

12.  Name  the  principal  disadvantages  of  the  cor- 
porate form.  Mention  two  kinds  of  enterprises  in 
which  these  disadvantages  outweigh  the  advantages. 


CHAPTER  II 

13.  What  are  the  legal  instruments  that  define  and 
control  a  corporation's  activities? 

14.  How  far  is  the  common  law  apphcable  to  cor- 
porations? 

15.  Is  it  important  to  consider  the  provisions  of  the 
constitution  of  the  state  in  which  a  corporation  is 
formed?    Why? 

16.  Discuss  the  relative  advantages  of  two  methods 
of  securing  authority  to  incorporate. 

17.  What  is  a  charter?  What  is  a  certificate  of 
incorporation?  What  are  articles  of  incorporation? 
What  information  should  a  charter  ordinarily  contain? 

18.  Draw  up  a  charter  for  a  company  (imaginary  or 
otherwise)  following  the  model  given  in  the  text. 

19.  Can  a  new  corporation  assume  a  name  which  has 
already  been  adopted  by  a  corporation  chartered  in 
some  other  state?  Do  any  of  the  states  prescribe  any 
part  of  the  names  of  corporations  organized  under  their 
laws? 

20.  Why  is  it  important  to  state  the  purposes  for 
which  a  company  is  formed  fully  and  carefully  in  the 
charter?    Why  did  the  New  Jersey  Court  of  Errors 


QUIZ  QUESTIONS  447 

and  Appeals  hand  down  a  decision  adverse  to  the  rail- 
road company  in  the  instance  cited  in  the  text? 

21.  What  is  the  minimum  number  of  incorporators 
in  most  states?  of  directors? 

22.  What  topics  are  usually  considered  in  the  by- 
laws of  a  corporation?  Draw  up  a  brief  set  of  by-laws 
for  a  company  (imaginary  or  otherwise)  following  the 
model  given  in  the  text. 

23.  What  are  the  usual  by-law  provisions  as  to  stock, 
meetings,  officers,  dividend  payments  and  by-law  amend- 
ments? How  may  new  rules  of  action  be  adopted 
without  the  formality  of  amending  the  by-laws? 


CHAPTER  III 

24.  What  are  the  four  fundamental  rights  of  the 
body  of  stockholders  of  a  corporation?  May  a  board 
of  directors  ordinarily  sell  the  assets  of  their  corpora- 
tion without  the  consent  of  the  stockholders? 

25.  Name  the  four  fundamental  rights  of  each  in- 
dividual stockholder.  What  is  a  proxy?  Write  a 
proxy  conferring  the  right  to  vote  in  favor  of  a  pro- 
posed amendment  at  a  special  meeting  called  for  the 
purpose  of  considering  the  amendment.  When  is  a 
proxy  irrevocable? 

26.  Can  stockholders  force  a  board  of  directors  to 
declare  a  dividend,  provided  the  company  is  admitted 
to  have  earned  large  profits?  What  is  meant  by  the 
"right  to  dividends"? 

27.  Does  a  stockholder  have  a  legal  right  to  inspect 
the  books  of  his  company?  How  does  the  movement 
in  favor  of  publicity  of  accounts  work  in  favor  of 
stockholders? 


us  CORPORATION  FINANCE 

28.  What  are  the  two  chief  universal  liabihties  of 
stockholders? 

29.  What  are  the  two  classes  of  creditors?  Has 
either  class  a  right  to  interfere  in  the  internal  manage- 
ment of  the  debtor  corporation? 

30.  What  are  ''dummy"  directors?  How  are  they 
sometimes  kept  under  control? 

31.  What  in  general  are  the  powers  of  a  board  of 
directors?  May  those  powers  be  delegated?  Under 
what  circumstances  do  directors  become  liable  for  loss 
suffered  by  their  corporation? 

32.  Why  is  it  stated  in  the  text  that  the  corporate 
form  is  "almost  ideally  adapted,  so  far  as  efficiency  and 
economy  go,  to  the  conditions  of  present-day  industry"? 


CHAPTER  IV 

33.  By  virtue  of  what  legal  principle  do  corpora- 
tions chartered  in  one  state  of  the  Union  extend  their 
operations  to  other  states?  Give  the  gist  of  the  de- 
cision of  the  Supreme  Court  in  the  case  of  The  Bank 
of  Augusta  vs.  Earle. 

34.  May  a  state  regulate  in  any  manner  corporations 
doing  business  within  its  borders,  but  chartered  in  an- 
other state?     If  so,  how? 

35.  Give  three  reasons  in  favor  of  securing  a  charter 
from  the  state  in  which  a  corporation  has  its  principal 
office.     Why  are  not  these  reasons  decisive  in  all  cases? 

36.  From  the  tables  given  in  the  text  estimate  the 
organization  fees  and  the  annual  franchise  taxes  of  a 
corporation  with  $50,000  capital  stock  in  New  Jersey, 
New  York,  Delaware,  Maine  and  South  Dakota.    What 


QUIZ  QUESTIONS  449 

other  expenses  will  probably  be  incurred  in  starting  a 
new  company? 

37.  Name  four  states  which  have  Hberal  incorpo- 
ration laws? 

38.  Why  is  it  desirable  to  secure  a  charter  in  a  state 
which  has  an  estabhshed  and  well-adjudicated  corpora- 
tion law? 

39.  Name  three  states  which  bear  poor  reputations  as 
states  of  incorporation.  Name  three  states  which  bear 
good  reputations. 

40.  If  you  were  about  to  incorporate  a  manufactur- 
ing company,  located  in  Massachusetts,  designed  both 
to  operate  a  plant  and  to  buy  up  the  stock  of  several 
competing  companies,  the  capitalization  to  be  $2,000, 
000,  in  what  state  would  you  take  out  a  charter?  What 
other  states  would  you  be  inclined  to  consider  favorably? 
Base  your  answer  on  the  data  given  in  the  text  and 
state  your  reasons  fully.  An  excellent  method  of  get- 
ting familiar  with  the  main  features  of  the  various 
state  laws  is  to  make  up  a  number  of  similar  hypo- 
thetical cases  and  consider  each  one  carefully. 

41.  What  is  a  "subscription  contract"  and  when  is 
it  used? 

42.  What  is  meant  by  the  statement  that  a  capable 
lawyer  can  generally  fit  out  any  corporation  with  the 
exact  powers  and  privileges  that  will  prove  most  ad- 
vantageous. 


CHAPTER  V 

43.  In  your  opinion  should  stock  certificates  be  made 
fully  negotiable?     Give  your  reasons  in  full. 

44.  What  is  the  "par  value"  of  a  share  of  stock?    The 

1—29 


450  CORPORATION  FINANCE 

"market  value"?    Is  there  any  good  reason  for  the 
custom  of  giving  shares  a  nominal  value  in  money? 

45.  Define  fully  "preferred  stock,"  showing  wherein 
the  preference  may  consist. 

46.  Name  and  discuss  four  uses  of  preferred  stock. 
What  is  "voting  stock"? 

47.  What  is  the  object  of  "cumulative  voting"? 
How  is  that  object  attained? 

48.  What  is  a  "voting  trust"?  What  is  the  usual 
plan  of  organization?  What  is  the  usual  object  in 
establishing  a  voting  trust? 


CHAPTER  VI 

49.  Define  "(juasi-public  corporations,"  "private  cor- 
porations," "close  corporations." 

50.  What  is  a  "parent  company"?  What  is  the 
difference  between  a  "parent  company"  and  a  "holding 
company"? 

51.  Why  does  a  holding  company  usually  aim  to  se- 
cure more  than  a  bare  majority  of  the  stock  of  its  subsid- 
iary companies?  What  is  the  distinction  between  the 
ordinary  balance-sheet  of  a  holding  company  and  its 
"consolidated"  or  "general"  balance  sheet? 

52.  Under  what  plan  were  the  early  "trusts"  or- 
ganized? Why  do  most  "trusts,"  so-called,  now  take 
the  form  of  holding  companies? 

53.  Taking  the  chart  of  organization  of  the  Inter- 
borough-Metropolitan  Company,  show  what  relation  of 
ownership  and  control  exists  between  the  New  York 
City  Railway  Company  and  the  Interborough-Metro- 
politan  Company. 

54.  How  many  companies  are  directly  controlled  by 


QUIZ  QUESTIONS  451 

the  Standard  Oil  Company  of  New  Jersey?      How 
many  indirectly? 


CHAPTER  VII 

55.  Enumerate  from  memory  the  principal  topics 
covered  in  the  Grst  six  chapters  of  this  book. 

56.  What  are  the  six  som:ces  of  corporate  funds?  In 
what  sense  may  profits  be  called  a  possible  source  of 
funds?  In  what  sense  do  trade  creditors  supply  cor- 
porate funds?  Can  a  corporation  manager  or  promoter 
ordinarily  seU  the  stock  or  bonds  of  his  company  to  a 
bank?     If  not,  why  not? 

57.  What  are  the  important  classes  of  investors? 

58.  How  would  you  distinguish  between  an  "invest- 
ment" and  a  "speculative"  security? 

59.  What  are  the  important  classes  of  buyers  of 
speculative  securities? 

60.  Why  is  it  desirable  that  a  corporation  should 
borrow  a  considerable  proportion  of  its  funds?  What 
proportion  of  the  funds  used  by  the  five  companies 
named  in  the  text  are  borrowed? 

61.  What  kinds  of  securities  ordinarily  will  a  cor- 
poration offer  in  order  to  secure  funds  from  (a)  trade 
creditors,  (b)  banks,  (c)  the  investing  public,  and  (d) 
the  speculative  public?  Name  and  describe  the  six  im- 
portant groups  of  corporate  assets.  What  securities 
may  be  issued  corresponding  to  each  group?  In  deter- 
mining what  securities  a  corporation  shall  issue  are  the 
earnings  of  the  corporation,  as  well  as  its  assets,  taken 
into  consideration?     If  so,  how? 


^62  CORPORATION  FINANCE 


CHAPTER  VIII 

62.  How  are  corporate  funds  secured  from  trade 
creditors?  What  two  qualifications  limit  the  general 
statement  that  a  corporation  should  buy  as  much  as  it 
can  on  credit?  What  is  a  conservative  percentage  of 
accounts,  bills  and  notes  payable  to  quick  assets? 

63.  What  are  the  main  points  that  will  be  considered 
by  a  careful  banker  in  determining  how  much  credit  he 
is  willing  to  extend  to  a  corporation? 

64.  What  are  the  essential  features  of  a  valid  nego- 
tiable promissory  note?  What  is  the  chief  objection 
to  using  short  or  medium  term  notes  sold  to  the  public 
as  a  means  of  securing  corporate  funds?  Under  what 
circumstances  is  it  good  financial  policy  for  a  corpo- 
ration to  issue  such  notes?  In  general  should  the  short- 
time  obligations  of  a  corporation  ever  be  based  on  the 
corporation's  permanent  assets? 


CHAPTER  IX 

65.  What  three  opinions  are  prevalent  as  to  the  chief 
factor  that  determines  the  value  of  fixed  assets? 

66.  What  are  the  characteristic  features  of  a  mort- 
gage? What  is  a  mortgage  bond?  What  is  a 
mortgage  deed  of  trust? 

67.  What  are  the  essential  and  usual  provisions  of 
a  corporate  deed  of  trust? 

68.  Define  '^closed,"  "open-end"  and  "hmited  open- 
end"  mortgage  deeds  of  trust?  Which  of  the  three 
types  is  generally  the  best?    Why? 


QUIZ  QUESTIONS  453 

CHAPTER  ES 

69.  Give  from  memory  the  principal  descriptive 
words  applied  to  corporate  bonds  indicating  (a)  their 
security,  (b)  their  purposes,  (c)  their  manner  of  pay- 
ment and  (d)  their  conditions  of  redemption. 

70.  What  is  a  junior  mortgage  bond?  How  is  the 
fact  that  it  is  a  junior  bond  sometimes  disguised? 

71.  What  are  sinking  fund  bonds?  What  are  the 
principal  objections  to  their  use? 

72.  What  are  collateral  trust  bonds?  Why  may  they 
sometimes  be  sold  more  readily  than  the  securities  on 
which  they  are  directly  based?  How  may  they  be  used 
to  finance  the  process  of  buying  control  of  subsidiary 
corporations? 

73.  What  is  an  equipment  trust  bond?  Why  are  they, 
so  highly  regarded  by  investors? 


CHAPTER  XI 

74.  Compare  English  with  American  practice  with 
reference  to  the  use  of  debenture  bonds.  What  reasons 
lead  to  the  issue  of  debenture  bonds  from  time  to  time 
by  some  corporations  in  this  country? 

75.  What  are  income  bonds?  What  is  the  chief  ob- 
jection to  their  use? 

76.  Define  "participating,"  "profit  sharing"  and 
"joint"  bonds  and  "receiver's  certificates." 

77.  What  are  registered  bonds?  Coupon  bonds? 
What  are  the  advantages  and  disadvantages  of  each 
form?    What  are  redeemable  bonds? 

78.  What  are  con\ertible  bonds?  What  are  their 
advantages  and  disadvantages  to  the  corporation? 


464  CQRPORATION  FINANCE 


CHAPTER  XII 

79.  What  is  a  promoter?  Does  he  have  a  legitimate 
and  useful  function  or  not?     'Give  your  reasons. 

80.  What  is  meant  by  the  promoter's  "discovery"  of 
a  proposition?  Illustrate  in  detail  with  reference  to 
some  hypothetical  case,  such  as  a  new  gold  mine  in 
Alaska  or  a  proposed  creamery  in  a  small  country  town. 

81.  What  is  meant  by  "assembhng"  a  proposition? 
Illustrate  in  detail  with  reference  to  the  same  hypo- 
thetical case  used  in  the  previous  question. 

82.  What  are  the  first  steps  in  financing  a  proposi- 
tion? What  is  the  advantage  of  carrying  the  develop- 
ment of  the  proposition  as  far  as  practicable  before 
asking  outsiders  to  supply  funds? 

83.  Why  should  a  promoter  usually  endeavor  to 
raise  more  money  in  advance  of  complete  development 
of  a  proposition  than  he  expects  will  be  needed? 

84.  Why  is  it  usually  better  for  a  promoter  to  sell 
to  a  large  number  of  small  buyers  than  to  a  small 
number  of  large  buyers? 

85.  To  whom  should  a  promoter  go  first,  generally 
speaking,  for  funds?    Why? 

86.  Show  how  the  principles  of  promotion  laid  down 
are  applied  in  the  illustration  given  in  the  text. 


CHAPTER  XIII 

87.  Why  are  professional  promoters  usually  unsuc- 
cessful in  the  long  run? 

88.  Why  do  lawyers  and  bankers  in  small  communi- 
ties do  a  considerable  amount  of  promotion  work?     To 


QUIZ  QUESTIONS  455 

what  extent  do  the  large  metropolitan  bankers  and 
promoters  enter  the  field  of  promotion? 

89.  What  are  the  advantages  of  engineering  firms 
as  promoters? 

90.  Is  a  promoter  in  any  sense  an  agent  of  his  cor- 
poration? A  promoter  buys  a  manufacturing  plant  for 
$10,000  and  sells  it  to  a  corporation  which  he  promotes 
for  $20,000,  representing  this  latter  sum  to  be  the  price 
he  paid  for  the  plant:  is  he  legally  entitled  to  his  $10,000 
profits?  If  not,  what  course  may  he  pursue  in  order  to 
evade  the  law? 

91.  Why  is  it  difiicult  to  enforce  the  principle  that 
misleading  statements  by  a  promoter  are  fraudulent? 

92.  A  promoter  makes  a  contract  on  behalf  of  his 
corporation  which  is  not  yet  formed:  how  may  the  cor- 
poration become  bound  by  this  contract  without  for- 
mally ratifying  it? 

93.  How  did  the  promoters  of  the  Rubber  Goods 
Manufacturing  Company  receive  their  pay?  Of  the 
American  Smelting  and  Refining  Company?  In  gen- 
eral what  two  plans  of  determining  a  promoter's  profits 
are  most  commonly  used? 

94.  What  are  the  chief  risks  and  tasks  that  a  pro- 
moter must  generally  assume? 

95.  Do  you  think  that  promoters  in  general  are  or 
are  not  overpaid?    Give  your  reasons. 


CHAPTER  XIV. 

96.  Why  is  there  a  strong  tendency  toward  consol- 
idation among  small  as  well  as  among  large  industrial 
establishments? 

97.  What  are  the  principal  difiiculties  that  are  apt 


456  CORPORATION  FINANCE 

to  confront  a  promoter  who  undertakes  to  consolidate 
several  existing  concerns? 

98.  Describe  briefly  the  process  of  "discovering"  a 
consolidation. 

99.  What  is  the  usual  method  of  "assembling"  a  con- 
solidation? What  is  a  "basis  of  consolidation"?  What 
are  the  characteristic  features  of  the  two  agreements 
cited  in  the  text? 

100.  Why  is  it  important  for  the  promoter  of  a  con- 
solidation to  consider  with  especial  care  the  means  of 
providing  his  new  corporation  at  the  outset  with  suffi- 
cient cash? 

101.  Why  does  the  promoter  of  a  consolidation  gen- 
erally try  to  raise  cash  by  means  of  a  bond  issue?  How 
may  he  manage  to  dispose  of  bonds  issued  by  a  new 
corporation  with  small  or  uncertain  assets? 

102.  How  does  the  problem  of  forming  a  large  con- 
solidation differ  from  the  problem  of  forming  a  small 
consolidation? 

103.  What  is  the  usual  basis  of  consolidation  or  ex- 
change and  how  is  it  determined? 

104.  What  was  the  basis  of  exchange  in  the  forma- 
tion of  the  Interborough-Metropolitan  Company?  In 
what  respects  was  it  faulty? 


CHAPTER  XV 

105.  What  were  the  conditions  under  which  the  steel 
business  of  the  United  States  was  conducted  in  the 
decade,  1890-1900? 

106.  What  were  the  chief  steel  companies  in  the  field 
in  1901  and  why  had  most  of  them  been  formed  in  the 
three  years,  1898-1901? 


I 


QUIZ  QUESTIONS  457 

107.  What  is  meant  by  "integration"  of  an  industry? 
How  did  this  factor  operate  to  bring  about  the  forma- 
tion of  a  great  steel  combination? 

108.  Why  was  not  the  promotion  of  the  United  States 
Steel  Corporation  an  especially  difficult  task?  Why 
were  the  four  Moore  companies  included  in  the  com- 
bination? What  was  the  original  capitalization  of  the 
United  States  Steel  Corporation? 

109.  Was  the  prospectus  issued  by  the  promoting 
syndicate  misleading?  How  much  cash  did  the  syn- 
dicate furnish? 

110.  What  were  the  approximate  profits  of  the  pro- 
moting syndicate? 

111.  What  percentage  of  the  stock  of  the  underlying 
companies  was  secured  by  the  Steel  Corporation?  Give 
from  memory  a  list  of  some  of  the  important  assets  of 
the  corporation. 

112.  What  have  been  the  principal  additions  to  the 
Steel  Corporation?  Give  briefly  the  terms  of  the  Hill 
ore  lease  and  of  the  Tennessee  Coal,  Iron  and  Railroad 
Company  deal.  What  is  the  approximate  cost  of  the 
steel  rail  mill  at  Gary,  Indiana? 

113.  Describe  briefly  the  preferred  stock  conversion 
plan  of  1902.  What  objections  were  raised  to  the  plan? 
What  important  changes  in  the  interior  financial  or- 
ganization of  the  corporation  have  been  made? 

114.  Give  briefly  the  argument  tending  to  show  that 
the  Steel  Corporation  is  greatly  over-capitalized.  Give 
briefly  the  argument  on  the  other  side  of  the  question. 

115.  What  in  general  is  the  policy  of  the  Steel  Cor- 
poration toward  its  employes?  Do  the  subsidiary  com- 
panies of  the  corporation  compete  with  each  other? 

116.  What  are  the  principal  outstanding  securities 
of  the  Steel  Corporation?     What  reasons  may  be  given 


458  CORPORATION  FINANCE 

for  expecting  that  these  securities  over  a  period  of 
years  will  rise  in  value? 


CHAPTER  XVI 

117.  Name  the  four  methods  of  selling  corporate 
securities. 

118.  What  are  the  characteristics  of  a  good  prospec- 
tus? Why  are  statements  in  speculative  prospectuses 
usually  vague? 

119.  Show  that  the  characteristic  features  of  specula- 
tive prospectuses  are  present  in  the  example  cited  in 
the  text. 

120.  What  are  the  characteristics  of  strictly  invest- 
ment prospectuses?  Is  it  safe  to  assume  that  these 
characteristics  are  never  apparent  except  when  the  se- 
curity offered  is  of  the  highest  grade? 

121.  What  would  be  the  characteristics  of  an  ideal 
prospectus? 

122.  What  are  the  advantages  and  disadvantages  to 
a  corporation  of  selhng  its  securities  through  large  bond 
and  banking  houses? 

123.  What  are  the  characteristics  of  large,  high-class 
banking  houses  in  contrast  to  disreputable  concerns  and 
what  are  the  essential  factors  that  make  a  proposition 
acceptable  to  them? 

124.  What  are  the  usual  banking  house  methods  of 
selling  securities?  Do  such  houses  guarantee  the  safety 
of  the  securities  they  sell? 


J 


QUIZ  QUESTIONS  [459 

CHAPTER  XVII 

125.  Name  the  principal  stock  exchanges  of  the 
United  States. 

126.  What  percentage  of  the  securities  handled  on 
the  New  York  Stock  Exchange  are  "listed"?  What 
are  the  requirements  for  listing? 

127.  What  is  the  "curb"  market  and  what  classes  of 
securities  are  bought  and  sold  in  this  market? 

128.  Describe  briefly  the  method  of  handling  trans- 
actions on  the  floor  of  a  stock  exchange. 

129.  What  is  the  relative  importance  of  speculative 
as  compared  with  investment  business,  and  what  func- 
tion is  performed  by  the  speculative  business? 

130.  Describe  the  process  of  buying  securities  "on 
margin." 

131.  Describe  the  process  of  selling  securities  "short." 

132.  What  are  the  characteristics  of  stock  exchange 
houses  in  contrast  to  "bucket  shops"? 

133.  Into  what  three  classes  may  Wall  Street  specu- 
lators be  divided? 

134.  Give  from  memory  a  brief  review  of  the  char- 
acteristics of  the  Wall  Street  security  market. 

135.  What  measures  may  be  taken  to  stimulate 
speculative  interest  in  a  security  that  is  about  to  be 
issued? 

136.  With  what  object  is  a  syndicate  frequently 
formed  to  assist  in  the  flotation  of  a  security? 

137.  By  the  use  of  what  methods  may  the  price  of 
a  stock  market  security  be  manipulated  and  kept  under 
control? 


460  CORPORATION  FINANCE 

CHAPTER  XVIII 

138.  What  is  underwriting?  How  did  the  practice 
and  the  word  originate? 

139.  What  are  the  chief  advantages  to  the  corpora- 
tion in  having  its  new  issues  underwritten? 

140.  What  are  the  advantages  to  the  buyers  of  se- 
curities? 

141.  When  is  underwriting  inadvisable?  What  is 
your  opinion  as  to  the  merits  of  the  Pennsylvania  Rail- 
road controversy  referred  to  in  the  text?  Give  your 
reasons. 

142.  Why  do  the  underwriting  houses  in  almost  every 
case  band  themselves  together  into  syndicates? 

143.  Describe  three  types  of  syndicates. 

144.  Describe  the  type  of  syndicate  in  which  the  sale 
of  the  security  is  pooled. 

145.  Describe  the  type  of  syndicate  in  which  the  un- 
derwritten issue  is  distributed  among  the  members  of 
the  syndicate. 

146.  Name  some  of  the  principal  underwriting 
houses.  What  is  the  distinction  between  a  bank  and  a 
banking  house? 

CHAPTER  XIX 

147.  Why  are  underwriting  syndicate  agreements 
frequently  quite  informal? 

148.  Make  an  abstract  showing  the  principal  points 
covered  in  the  agreement  of  the  syndicate  formed  to 
underwrite  the  preferred  stock  conversion  of  the  United 
States  Steel  Corporation. 

149.  Mention  two  general  characteristics  of  under 
writing  agreements. 


i 


QUIZ  QUESTIONS  461 

150.  With  what  three  classes  of  corporations  do  un- 
derwriting syndicates  deal? 

151.  What  are  the  peculiar  problems  and  difficulties 
involved  in  underwriting  the  security  issues  of  new  or 
speculative  corporations? 

152.  Review  from  memory  the  example  of  specula- 
tive underwriting  given  in  the  text  and  make  sure  that 
you  understand  thoroughly  all  the  operations  involved. 
What  conditions  made  possible  the  construction  of  a 
new  plant  in  this  case  wholly  with  borrowed  funds? 
What  principles  followed  in  this  case  are  applicable  in 
all  cases  where  it  is  desired  that  an  undeveloped  corpo- 
ration should  borrow  as  much  as  possible? 


CHAPTER  XX 

153.  What  mistake  is  frequently  made  in  the  invest- 
ment of  the  original  capital  funds  of  a  corporation? 

154.  What  are  the  advantages  of  the  installment 
method  of  getting  funds  for  a  corporation  only  as  the 
funds  are  needed? 

155.  What  are  the  disadvantages  of  this  method? 

156.  What  are  the  other  possible  methods  of  getting 
cash  as  needed,  when  the  total  amount  necessary  cannot 
be  accurately  foreseen? 

157.  What  considerations  determine  how  large  an 
amount  must  be  invested  by  a  corporation  in  fixed  cap- 
ital?   What  is  working  capital? 

158.  What  are  the  four  forms  which  working  capital 
may  take? 

159.  What  factors  determine  how  large  an  amount 
of  working  capital  should  be  carried  by  a  corporation? 

160.  Of  the  companies  named  in  the  text  which  one 


463  CORPORATION  FINANCE 

has  the  largest  percentage  of  working  capital  to  gross 
business?     Can  you  suggest  any  reason? 

161.  What  are  the  five  factors  that  immediately  affect 
working  capital  and  determine  its  amount?  Why  do 
railroads  require  only  a  small  proportion  of  working 
capital? 

162.  About  how  much  working  capital  did  the  Penn- 
sylvania Railroad  Company  carry  in  1908?  Why  was 
this  amount  greater  than  that  carried  by  most  railroad 
companies? 

163.  Why  is  it  of  the  utmost  importance  that  a  cor- 
poration should  be  suppHed  with  the  proper  amount  of 
working  capital? 


CHAPTER  XXI 

164.  Draw  up  from  memory  a  model  corporate  in- 
come statement,  arranging  the  items  in  their  proper 
order. 

165.  By  what  common  methods  may  a  company's 
statement  of  gross  earnings  be  padded? 

166.  What  expenditures  and  what  reserves  should 
always  be  included  under  the  head  of  operating  ex- 
penses? 

167.  What  are  the  causes  of  depreciation?  What  is 
a  depreciation  reserve?  What  method  of  allowing  for 
depreciation  has  been  in  common  use  among  steam  and 
electric  railroad  companies?  Is  a  depreciation  reserve 
usually  set  aside  as  a  separate  sum  to  be  invested  outside 
the  corporate  business? 

168.  Why  should  "income  from  other  sources"  be 
stated  separately?  Why  should  cumulative  preferred 
dividends  be  paid  regularly,  if  practicable? 


QUIZ  QUESTIONS  463 

169.  Should  a  corporation  ordinarily  pay  out  all  its 
profits  in  the  form  of  dividends  to  its  stockholders?  If 
not,  why  not? 

170.  What  four  factors  determine  the  amount  of 
profits?  What  industries  are  apt  to  have  the  most 
regular  profits?  Why  are  the  profits  of  railroad  equip- 
ment companies  so  variable? 

171.  Why  is  it  desirable  that  a  corporation  should 
establish  and  maintain  from  year  to  year  a  regular 
dividend  rate?  How  may  regularity  of  dividends  be 
secured  in  spite  of  irregularity  of  profits? 

172.  Why  is  great  prudence  and  foresight  on  the 
part  of  the  directors  in  declaring  dividends  essential  to 
the  best  interests  of  a  corporation? 


CHAPTER  XXII 

173.  What  are  the  two  important  classes  of  better- 
ments? 

174.  What  are  the  three  important  sources  of  funds 
for  betterments? 

175.  What  are  the  advantages  of  providing  for  bet- 
terments by  appropriations  from  earnings? 

176.  What  are  the  two  objections  to  this  method? 

177.  What  three  motives  may  lead  stockholders  to 
oppose  a  policy  of  providing  for  betterments  by  appro- 
priations from  earnings?  How  do  corporation  officers 
sometimes  manage  to  follow  this  policy  without  the 
consent  of  even  a  majority  of  stockholders? 

178.  Review  briefly  from  memory  the  case  of  the 
Lehigh  Valley  Railroad  Company  and  show  how  Presi- 
dent Walters  for  some  years  pursued  the  policy  referred 
to  above. 


464  CORPORATION  FINANCE 

179.  Show  how  the  Union  Bag  and  Paper  Company 
is  now  profiting  by  reason  of  having  previously  pursued 
this  policy. 

180.  When  and  how  may  funds  for  betterments  safely 
be  borrowed? 

181.  What  policy  as  to  provision  for  betterment  ex- 
penditures is  followed  by  the  Pennsylvania  Railroad? 

182.  What  are  the  comparative  merits  of  bond  and 
of  stock  issues  as  means  of  raising  funds  for  better- 
ments? 

CHAPTER  XXIII 

183.  Define  "surplus." 

184.  Give  and  discuss  briefly  four  sources  of  surplus. 

185.  What  is  the  fifth  source  of  surplus?  Can  a 
surplus  be  built  up  to  any  considerable  amount  by  this 
method? 

186.  What  was  the  policy  of  most  of  the  industrial 
trusts  as  to  surplus  in  the  first  few  years  of  their  exist- 
ence?    What  were  the  results  of  their  policy? 

187.  How  may  a  surplus  be  invested?  What  general 
principle  should  be  followed? 

188.  What  is  meant  by  using  the  surplus  as  a  "rainy 
day  fund"?  What  companies  follow  this  practice? 
What  is  the  argument  in  its  favor?  What  are  its  dis- 
advantages? 

189.  What  is  the  usual  practice  in  this  country  with 
reference  to  the  use  of  a  surplus? 

CHAPTER  XXIV 

190.  What  should  be  the  effect  on  dividends  of 
putting  a  surplus  back  into  the  property  of  a  corpora- 


QUIZ  QUESTIONS  465 

tion?  Is  the  effect  ever  to  increase  dividends  in  a  pro- 
portion greater  than  the  proportion  of  surplus  so  in- 
vested to  the  original  corporate  capital?     If  so,  when? 

191.  How  may  stock-watering  be  a  method  of  dis- 
tributing a  surplus  to  stockholders?  Give  an  illustra- 
tion. Why  is  it  that  a  stock  paying  a  regular  dividend 
of  4  per  cent  often  sells  for  more  than  half  as  much  as  a 
stock  paying  an  equally  regular  and  certain  dividend 
of  8  per  cent? 

192.  What  are  subscription  privileges?  How  may 
they  be  used  as  a  method  of  distributing  surplus? 

193.  How  does  a  subscription  privilege  give  an  op- 
portunity for  cheap  investment?  What  four  methods 
may  be  used  by  stockholders  in  order  to  secure  quick 
cash  profits? 

194.  What  is  the  method  known  as  the  "subsequent 
sale"?    What  are  the  objections  to  its  use? 

195.  What  is  the  "short  selling"  method?  What  is 
the  objection  to  its  use? 

196.  What  is  the  method  known  as  "sale  of  old 
stock"?     Why  cannot  it  always  be  used. 

197.  What  is  the  method  known  as  "sale  of  rights"? 
What  is  meant  by  a  "right"  in  New  York?  What  does 
the  same  word  mean  in  Philadelphia?  What  is  the 
objection  to  the  use  of  this  method? 

198.  What  factors  determine  the  theoretical  value  of 
a  right?  What  is  the  formula  commonly  used  on  the 
New  York  Stock  Exchange?  Why  is  the  market  value 
of  a  right  usually  less  than  its  theoretical  value? 

199.  Is  the  granting  of  privileged  subscriptions  a 
method  of  stock  watering?  Are  they  objectionable  on 
that  account? 


1—30 


466  CORPORATION  FINANCE 


CHAPTER  XXV 


200.  What  good  reason  can  you  give  for  taking  up 
the  study  of  corporate  manipulation? 

201.  Is  it  true  that  the  corporate  form  favors 
manipulation?    Why? 

202.  Is  any  force  at  work  in  the  financial  and  in- 
dustrial world  which  has  a  strong  tendency  to  check 
manipulation? 

203.  What  four  classes  or  bodies  of  persons  may 
endeavor  to  manipulate  a  corporation  for  their  own 
benefit? 

204.  How  may  high  salaries  be  used  as  a  method  of 
manipulation? 

205.  How  may  the  power  to  bind  a  corporation  by 
purchases  and  contracts  become  a  means  of  manipula- 
tion? Is  it  usually  possible  to  find  a  legal  remedy  or 
punishment? 

206.  How  may  the  power  to  form  new  companies  to 
handle  especially  profitable  business  be  used  as  a  method 
of  manipulation?  How  was  this  principle  applied  by 
Commodore  Vanderbilt? 

207.  How  may  a  corporate  officer  manipulate  a  cor- 
poration by  reason  of  having  "inside"  information? 

208.  Is  there  reason  to  think  that  the  use  of  these  four 
methods  of  manipulation  is  not  uncommon? 


CHAPTER  XXVI 

209.  Why  do  not  directors  who  wish  to  manipulate  a 
corporation  in  their  own  interest  enrich  themselves  by 
voting  exorbitant  fees  to  themselves?  What  four 
methods  do  such  directors  commonly  use? 


QUIZ  QUESTIONS  467 

210.  How  may  directors  misuse  their  power  to  make 
contracts  on  behalf  of  their  corporation?  Illustrate  by 
reference  to  the  case  of  the  Minnesota  railroad  company 
cited  in  the  text. 

211.  Why  do  not  the  courts  interfere  in  such  cases? 

212.  How  may  directors  manipulate  by  forming 
new  companies  or  transferring  credit  or  assets  of  their 
company  to  some  other  company?     Give  an  illustration. 

213.  State  a  few  methods  of  juggling  the  accounts  of 
corporations  which  are  not  infrequent.  How  may 
directors  profit  by  juggling  the  accounts  of  their  cor- 
poration? 

214.  What  is  meant  by  "window-dressing"?  How 
may  it  be  used  by  directors  as  a  method  of  manipula- 
tion? 

215.  What  remedies  for  this  kind  of  manipulation 
may  be  suggested? 

216.  How  may  directors  secure  gain  for  themselves 
by  inflicting  loss  or  even  bankruptcy  on  their  corpora- 
tion?    Give  two  illustrations. 

217.  Review  the  essential  features  of  the  case  cited 
in  the  text.  How  might  the  manipulation  of  the  cor- 
poration in  this  case  have  been  prevented? 


CHAPTER  XXVII 

218.  How  may  stockholders  fraudulently  secure 
profit  for  themselves  at  the  expense  of  the  creditors  of 
the  corporation? 

219.  What  are  the  essential  facts  in  the  well-known 
case  of  Chicago  and  Alton  Railroad  Company? 

220.  How  may  subsidiary  companies  be  used  as  a 


468  CORPORATION  FINANCE 

means  of  manipulating  a  corporation  and  defrauding 
creditors?     Illustrate. 

221.  Review  the  main  facts  in  the  Central  of  Georgia 
Railway  case  cited  in  the  text. 

222.  Show  how  the  minority  stockholders  in  a  cor- 
poration may  be  "squeezed"  by  wilful  mismanagement 
on  the  part  of  the  majority  stockholders  and  illustrate 
by  reference  to  the  case  of  the  Olympic  Theatre  Com- 
pany cited  in  the  text. 

223.  Review  from  memory  the  series  of  transactions 
in  the  real  estate  proposition  cited  in  the  text  and  show 
exactly  how  the  minority  stockholders  in  the  Long  View 
Land  Company  were  defrauded. 

224.  Review  from  memory  the  series  of  operations 
carried  on  by  L.  A.  Ehrenbahn  cited  in  the  text  and 
show  how  they  all  worked  in  favor  of  the  manipulation 
of  his  deceased  brother's  estate  in  his  own  interest. 

225.  Mention  four  measures  preventive  of  manipula- 
tion that  should  be  taken  by  honest  stockholders. 


CHAPTER  XXVIII 

226.  Distinguish  between  "true"  and  "legal"  in- 
solvency. 

227.  Mention  four  possible  causes  of  true  insolvency. 

228.  What  are  the  chief  causes,  according  to  Brad- 
street's  table,  of  legal  insolvency?  What  is  the  real 
meaning  of  the  phrase  "lack  of  capital"  when  used  in 
this  connection? 

229.  What  were  the  two  causes,  according  to  the  Wall 
Street  Journal  of  the  failure  of  the  Detroit,  Toledo 
and  Ironton  Railway  Company  in  1909? 


QUIZ  QUESTIONS  469 

230.  Mention  three  immediate  causes  of  legal  in- 
solvency in  addition  to  "lack  of  capital." 

231.  What  is  bankruptcy?  Can  a  corporation  be- 
come a  voluntary  bankrupt?  Can  all  corporations  be- 
come involuntary  bankrupts?  Is  dissolution  of  the  cor- 
poration a  common  method  of  handling  insolvency?  If 
not,  why  not? 

232.  What  is  a  "bill  in  chancery"?  By  whom  may| 
it  be  presented?  How  may  a  friendly  receiver  for  a 
corporation  be  obtained?  What  courts  have  jurisdic- 
tion in  cases  of  corporate  insolvency  and  receiverships? 

233.  What,  briefly  stated,  are  the  duties  of  the  re- 
ceiver of  a  failed  corporation? 

234.  From  what  source  does  he  obtain  his  authority? 
How  are  his  powers  limited?  May  he  incur  debts  bind- 
ing on  the  insolvent  corporation  ?     Does  he  receive  a  fee  ? 


CHAPTER  XXIX 

235.  Why  is  it  usually  necessary  and  desirable  to  re- 
organize large  insolvent  corporations  rather  than  to  sell 
their  property  and  distribute  the  assets  among  the 
creditors? 

236.  Why  is  the  formation  of  committees  usually  the 
first  step  in  reorganization?  How  are  these  committees 
appointed?  How  much  authority  do  they  possess? 
How  may  a  general  reorganization  committee  be 
formed. 

237.  Why  are  bondholders  usually  ready  to  agree  to 
a  reorganization  rather  than  foreclose  and  force  a  sale 
and  distribution  of  assets? 

238.  What  are  the  main  problems  and  difficulties  that 
confront  a  general  reorganization  committee?    How 


470  CORPORATION  FINANCE 

are  the  relative  standing  and  value  of  the  various  issues 
of  mortgage  bonds  and  other  claims  on  the  corporation 
determined?  What  concession  is  usually  made  to  the 
stockholders  of  the  corporation? 

239.  Name  the  four  main  objects  of  every  reorgani- 
zation. Why  is  it  necessary  usually  to  raise  considerable 
amounts  of  cash? 

240.  What  are  the  three  possible  methods  of  raising 
cash?  Why  do  almost  all  reorganizations  of  insolvent 
corporations  involve  assessments  on  security  holders? 
How  large  may  the  assessments  on  stockholders  be  made? 
Under  what  circumstances  may  bondholders  be  induced 
to  pay  assessments? 

241.  What  three  classes  of  fixed  charges  are  usually 
reduced  in  reorganization?  What  threat  may  be  used 
to  force  an  acceptance  of  a  reasonable  reduction?  What 
principle  is  usually  followed  in  determining  the  maxi- 
mum total  amount  of  fixed  charges  to  be  imposed  upon 
the  reorganized  company? 

242.  How  are  bondholders  usually  compensated  for 
the  reduction  in  their  yearly  interest?  What  is  the 
effect  on  the  total  capitalization  of  the  company?  What 
factors  determine  whether  or  not  the  reorganized  com- 
pany shall  operate  under  the  charter  of  the  old  com- 
pany? Why  is  a  voting  trust  frequently  formed  at  the 
time  of  organization? 

243.  Summarize  briefly  from  memory  the  principles 
of  reorganization  laid  down  in  this  chapter. 


CHAPTER  XXX 

244.  Sketch  from  memory  the  growth  of  the  Santa 
Fe  System.     What  were  the  effects  on  the  company's 


QUIZ  QUESTIONS  471 

financial  strength  of  the  rapid  expansion  in  the  j^ears 
1884-1888? 

245.  What  were  the  main  results  of  the  reorganiza- 
tion of  1889  ?  What  were  some  of  the  events  that  led  up 
to  the  failure  of  the  company  in  1893? 

246.  What  was  the  substance  of  the  so-called  English 
plan  of  reorganization?  Why  was  it  not  adopted? 
What  were  the  main  features  of  the  plan  that  was  finally 
adopted?  What  have  been  the  results  of  this  reor- 
ganization? 

247.  Sketch  from  memory  the  growth  of  the  Rock 
Island  System. 

248.  Outline  the  plan  of  reorganization  brought  for- 
ward in  1902.  What  was  the  prime  object  of  this  re- 
organization? Was  that  object  attained?  Show  how 
control  of  the  Rock  Island  System  may  have  been  se- 
cured by  the  Moore  crowd  without  any  permanent  out- 
lay? 

249.  Why  did  the  Westinghouse  Company  fail? 
What  was  the  main  problem  that  confronted  the  reor- 
ganization committees?  What  were  the  main  features 
of  the  plan  adopted? 


INDEX 


Accountant's  work  in  consolidation, 

182-183. 
Adaptability    of     corporate     form, 

5-8. 
Addicks,  J.  Ed.,  19. 
"  Alien  "  corporations,  51. 
American  Bridge  Co.,  203,  210. 
American  Ice  Co.,  397-398. 
American  Law  Review,  350. 
American  Locomotive  Co.,  119. 
American  Sheet  Steel  Co.,  205,  208, 

215. 
American  Steel  and  Wire  Co.,  200, 

203,  204,  206,  207,  215. 
American  Steel  Hoop  Co.,  203,  208, 

215. 
American  Telephone  and  Telegraph 

Co. 
Number  of  stockholders,  7. 
Watered  stock,  338. 
American  Tin  Plate  Co.,  203,  208, 

215. 
American  Thread  Co.,  98,  101,  106. 
Appointment  of  receiver,  403-404. 
Argentine  Republic  bonds,  23. 
Arizona,  corporate  laws  of,  54,  57, 

58. 
Atchison,  Topeka  and  Santa  F^  R. 

R.  Co.,  298,  409. 
First  reorganization,  429-431. 
Growth,  426-428. 
Second  reorganization,  431-434. 
Atlantic  and  Pacific  R.  R.  Co.,  427. 
Atwood,  Albert  W.,  196. 


Bad  management,  396. 
Balance  sheets,  82-83. 


Baldwin  Locomotive  Works,  313. 
Baltimore  and  Ohio  R.  R.  Co.,  129. 
Bank  of  Augusta  vs.  Earle,  49-51. 
Bank  Loans,  108-109. 
Bankruptcy    and    insolvency,    401- 

403. 
Banks,  function  of,  93. 
Bay  State  Gas  Co.,  19. 
Bethlehem    Steel    Corporation,    98, 

101,  107,  117. 
Betterment  expenses,  313,  314. 
Borrowing  funds  for,  321-322. 
Classes  of,  311-312. 
Conclusions  as  to,  323-324. 
Lehigh  Valley  R.  R.  policy,  316- 

320. 
Pennsylvania  R.   R.  policy,  322- 

323. 
Sources  of  funds  for,  312-313. 
Stockholders'      attitude      toward, 

314-316. 
Union  Bag  and  Paper  Co.  policy, 
320-321. 
Bill  in  Chancery,  403. 
Blackstone,  2,  4. 
Bonds,  see  "Corporate  Bonds." 
Booth,  A.  &  Co.,  99,  101,  107. 
Boston  and  Maine  R,  R.  Co.,  145- 

146.  * 

Bucket  shops,  248-S50. 
By-laws,  26-34. 


California,  corporate  laws  of,  57. 
Capital,  lack  of,  397-398. 
Capitalization, 

Factors  affecting,  102,  104. 

In  reorganization,  422-424. 

Of  U.  S.  steel  Corporation,  216. 
Carnegie,  Andrew,  199,  204. 


473 


474 


INDEX 


Carnegie  Steel  Co.,  99,  201,  203,  204, 

206,  209,  216,  300,  301,  313,  336. 

Central  of  Georgia  R.  R.  Co.,  383- 

385. 
Centralization    of    corporate    man- 
agement, 9-10. 
Charter, 

Essential  features  of,  20-22. 
Important  feature  of,  28. 
Where  to  obtain,  62. 
Chicago  and  Alton  R.  R.  Co.,  380- 

382. 
Chicago,    Burlington   &   Quincy   R. 

R.  Co.,  134. 

Chicago,  Rock  Island  &  Pacific  R. 

R.  Co.,  337,  435,  437,  438,  439. 

Chicago,    Rock    Island    &     Pacific 

Railway  Co.,  337,  435,  437,  439, 

440. 

Choctaw,  Oklahoma  and  Gulf  R.  R., 

437. 
Classification  of  corporations. 
Close,  80. 

Holding  companies,  81-87. 
Large,  80. 
Non-stock,  79. 
Open,  80. 

Parent  companies,  80-81. 
Small,  80. 
Stock,  79. 
Colorado  Midland  R.  R.,  430. 
Commission  on  Uniform  State  Laws, 

65-66. 
Common  law  of  corporations,  17-18. 
Connecticut,  corporation  laws  of,  57, 

58-59. 
Contracts, 

Manipulation   by    directors,    362- 

365. 
Manipulation  by  officers,  353-355. 
Conway,  Jr.  Dr.  Thomas,  162. 
Conyngton,  Thomas,  22,  29,  53. 
Corporate  bonds, 

Collateral  trust,  133-135. 
Convertible,  151-153. 
Debenture,  141-144. 
Equipment  trust,  135-140, 
Gold,  152. 


Income,  144-147. 

Joint,  147,  149. 

Names  of,  130. 

Manner  of  payment  of,  128. 

Mortgage,  121-122,  129. 

Participating,  14v. 

Payment  of,  149,  151. 

Profit-sharing,  147. 

Purposes  of,  128,  149-151. 

Receivers'  certificates,  149. 

Redeemable,  151. 

Redemption  of,  128,  141-151. 

Registered,  151. 

Security  of,  127-128. 

Sinking  fund,  130-133. 

Serial,  151. 
Corporate  entity,  3. 
Corporate  form,  abuse  of,  350. 
Corporate  funds. 

Borrowing,  96-102. 

Security  issues,  102-104. 

Sources  of,  91-96. 
Corporate  mortgage. 

Closed,  125-126. 

Deed  of  trust,  122-125. 

Limited  open-end,  125-126. 

Open-end,  125-126. 

Trustee  under,  380. 
Corporate  name,  24. 
Corporate  purposes,  24-28. 
Corporate  organization,  53. 

Efficiency  of,  47-48. 

Flexibility  of,  64. 
"Corporation  Finance,"  97. 
Corporation  laws, 

Comparative  summary,  58-62. 

Liberality  of,  55-56. 

Permanence  of,  56-57. 

Reputation  of,  57-^8. 
Corporations  in  ancient  nations,  4. 
Corporations, 

Definitions  of,  2. 

Right  to  do  business  in  foreign 
states,  49-51. 

Statements  to  banks,  108-109. 
Cunard  Co.,  332. 
Curb  market,  242-243. 


INDEX 


475 


Daggett,  Stuart,  426-427. 
Dartmouth  College  case,  2. 
Deed  of  trust,  123. 
Delaware,  corporate  laws  of,  53,  54, 

56,  57,  59. 
Detroit,   Toledo  and   I  ronton   Rail- 
way Co.,  398-400. 
Deductions  from  income,  303. 
Defining     and     controlling     instru- 
ments, 17. 
Depreciation  reserves,  299-302. 
Dill,  James,  B.,  25. 
Directors, 

"  Dummy,"  44-45. 
Liabilities  of,  45-47. 
Manipulation  by,  364-375. 
District    of    Columbia,    corporation 

laws  of,  54,  57,  59-60. 
Dissolution,  403. 
Disadvantages    of   corporate    form 

13-16. 
Dividends, 

Cumulative,  72. 
Fluctuations  in,  308. 
Non-cumulative,  72. 
Paying,  303-304,  309-310. 
Reductions  in,  314. 
Regularity  of,  308-309. 
*'  Domestic  "  corporations,  51. 
"Dummy"  directors,  44-45. 


Federal  Steel  Co.,  200,  203,  204,  206, 

207,  215. 
Fixed  assets,  327. 

Value  of,  119-121. 
Foreign  corporations,  51. 
Fraud,  396-397. 
Frick,  H.  C.  Coke  Co.,  201. 


Gates,  John  W.,  215. 
General  Electric  Co.,  291-292. 
Government  control  of  corporations, 

15-16. 
Greene,  Thomas  L.,  97. 
Gross  earnings, 

Determination  of,  297-298. 

Statement  of,  298. 
Gulf,  Colorado  &  Santa  F6  R.  R., 
427. 


H 


Hall,  Henry,  152. 
Harriman,  E.  H.,  315. 
Hamburg-American  Line,  332. 
Herring-Hall-Marvin  Safe  Co.,  97- 

98,  106. 
Hyde,  James  H.,  266. 


Eastman  Kodak  Co.,  231. 
EflSciency  of  corporate  organization, 

47-48. 
Electric  railroads,  307. 
Equipment  companies,  306. 
Equipment  trust  bonds,  137. 
Erie  Railroad  Co.,  117. 
Essential   features  of  by-laws,  33- 

36. 
Essential  features  of  charter,  20-22. 
Expenses  of  incorporation,  13-14. 


Illinois  Central  R.  R.  Co.,  340,  346. 
Illinois,  corporation  laws  of,  57. 
Important  feature  of  charter,  28. 
Incorporation, 

Agreements  prior  to,  63-64. 

Expenses  of,  53-55. 

Where  to  incorporate,  52-53. 

Wide  range  of  choice  in,  64. 
Income,  302-303. 
Income  bonds,  144-147. 
Influence  of  corporations,  16. 
Individuals    interested    in    corpora- 
tion, 37. 
Inheritance  of  surplus,  326. 


476 


INDEX 


Inside  information,  358-360. 
Insolvency, 
Causes  of  legal,  397-398,  400-401. 
Causes  of  true,  395-397. 
Detroit,   Toledo  &  I  ronton,  398- 

400. 
Methods  of  handling,  401^04. 
Installment  method  of  getting  cash, 

284-287. 
Integration,  202. 
Interborough-Metropolitan   Co.,  86- 

87,  253. 
International  Harvester  Co.,  291. 
Interstate    Commerce    Commission, 

301,  372,  380. 
Inventions,  302. 
Investment, 
Amount  in  fixed  capital,  288-289. 
Amount  in  working  capital,  290- 

291,  293-294. 
Definition  of,  94-95. 
Importance  of,  284. 
Of  surplus,  330,  340. 
Practice    of    large    corporations, 
291^93. 


Jones  and  Laughlin  Steel  Co.,  206. 
Journal    of    Accountancy,    66,    110, 
183. 


Lack  of  capital,  395-396. 

Lawson,  Thomas  W.,  20. 

Leeds,  Wm.  B.,  436. 

Lehigh  Valley  R.  R.  Co.,  316-320, 

344. 
Liabilities, 
Of  directors,  45-47. 
Of  stockholders,  42-44. 
Of      stockholders      of     National 

Banks,  12. 
Limited  credit  of  corporations,  14- 

15. 
Limited  liability  of  corporations,  11- 

13. 
Limited  powers  of  corporations,  14. 
Little,  Stephen,  298,  431. 


M 


Maine,  corporation  laws  of,  53,  54, 

56,  57,  60. 
Manipulation  by  directors, 

Accountant's  statement,  370-371. 
Attitude  of  courts,  365-366. 
Contracts,  362-365. 
Juggling  accounts,  367-370. 
Loss   of  control   dangerous,   375- 

378. 
Loss  to  corporation,  373-375. 
Methods  of,  362. 
New  companies,  366-367. 
Remedies,  371-373. 
Manipulation  by  officers. 
Contracts,  353-355. 
Corporate  form  favors,  349-350. 
Methods  of,  352. 
Misuse     of     inside     information, 

358-360. 
Necessary  evil,  350-351. 
New  companies,  355-358. 
Ought  we  to  study,  349. 
Remedy,  351. 
Salaries,  352-353. 
Manipulation  by  and  for  stockhold- 
ers. 
Central  of  Georgia  R.  R.  income 

account,  383-385. 
Chicago  and  Alton  deal,  380-382. 
Creditors,  causing  loss  to,  379-380. 
Ocean  Steamship  Co.,  384. 
Remedies,  392-393. 
Squeezing    minority    stockholders, 

385-387. 
Subsidiary  companies,  382-383. 
Marshall,  Chief  Justice,  2. 
Massachusetts,  corporation  laws  of, 

57,  60-61. 
McPherson,  F.  H.,  184. 
Meade,  Edward  S.,  84,  132,  204,  318, 

329. 
Meetings  of  stockholders,  34. 
Method  of  creating  corporation,  19- 

20. 
Method  of  getting  cash,  287-288. 
Midvale  Steel  Co.,  41. 


INDEX 


477 


Minnesota,  corporation  laws  of,  57. 

Moore  Companies,  203,  206. 

«  Moore  Crowd,"  436,  437,  438,  439. 

Morgan,  J.  P.,  205. 

Morgan,  J.  P.  &  Co.,  269,  277. 

Mortgage  bond,  nature  of,  121-122. 

N 

National   Steel   Co.,   201,    203,   204, 

207,  215. 
National   Tube   Co.,   201,   203,   204, 

206,  207. 
Nevada,  corporation  laws  of,  61. 
New  Jersey, 

Corporation   laws   of,   53,   54,   56, 

57,  61-62,  84r-85. 
Incorporation  of  U.  S.  Steel  Cor- 
poration, 206. 
New  Jersey  Court  decision,  26-27. 
New  York,  corporation  laws  of,  53, 

54,  56,  57,  58,  62. 
New  York  Central  R.  R.  Co.,  304- 

357. 
New  York  Curb  Market,  344. 
New  York   Evening   Post,   261-262. 
New  York,  New  Haven  &  Hartford 

R.  R.  Co.,  144. 
New  York  Stock  Exchange,  346. 
"  Non-stock  "  corporations,  1. 
Northern     Pacific-Great     Northern, 

134,  149. 

O 

Obligations,  quick,  401. 
Ocean  Steamship  Co.,  384. 
Officers  of  Corporation,  34-35. 
Oliver  Mining  Co.,  201. 
Operating  expenses,  298-299. 
Oregon  Short  Line,  147,  409. 
Over-estimation  of  assets,  395. 
Ownership  of  stock,  33-34. 


Pennsylvania, 

Corporation  laws  of,  57. 
Cumulative  voting  required,  18-19, 

77. 


Pennsylvania  R.  R.  Co.,  260-261. 
Annual  report  of,  322-323. 
Number  of  stockholders,  7. 
Policy  of,  322. 
Perkins,  George  W.,  266. 
Permanence  of  corporations,  8-9. 
Personality  of  corporations,  3-4,  8, 

17. 
Petition  for  receiver,  403. 
Philadelphia  Stock  Exchange,  348. 
Pittsburg,  Bessemer  and  Lake  Erie 

R.  R.,  201. 
Pittsburg  Steamship  Co.,  201. 
Pooling,  83. 

Popularity  of  corporate  form,  5. 
Post,  William,  110. 
Powers  of  directors,  45-47. 
Prices  of  raw  materials,  305. 
Production    percentages    of    indus- 
trial companies,  305-306. 
Profits,  variability  of,  304-308. 
Promoters, 

Bankers  as,  169. 

Contracts  by,  175. 

Definition,  154. 

DiflBculties  of,  181-182. 

Engineering  firms  as,  169-171. 

Function  of,  154-156. 

Lawyers  as,  169. 

Misleading    statements    by,    174- 

175. 
Pay  of,  175-177,  178-179. 
Professional,  167-169. 
Risks  and  labors  of,  177-178. 
Secret  profits  of,  171-179. 
Promotion, 

Assembling    a    proposition,    157- 

158. 
Basis    of    consolidation,    183-190, 

195-196. 
Discovery  of  a  proposition,  156- 

157. 
Discovery  of  small  consolidation, 

182-183. 
Distribution  of  stock,  161. 
Financing  a  proposition,  158-159. 
Illustration  from  Electric  R.   R. 
Co.,  162-166. 


478 


INDEX 


Methods  of  raising  cash,  191-193. 

Necessity  for  cash,  190-191. 

Of  industrial   combinations,   180- 
181. 

Of   Interborough   -   Metropolitan 
consolidation,  196-198. 

Providing  funds,  160-161. 

Sale  of  stock,  161-162. 
Prospectus, 

Characteristics  of,  224r^26. 

Ideal,  230-231. 

Investment,  228-230. 

Speculative,  226-228. 
Proxy,  38-40. 
Purposes  of  U.  S.  Steel  Corporation, 


Q 


Quick  Obligations,  401. 


R 


Railroad  reorganization,  426. 
Railroads  reorganized  in  1907,  425. 
Receivers'  certificates,  148,  149. 
Receiver, 

Duties  of,  404-406. 

Powers  of,  406-407. 
Regulation   of  "  foreign "   corpora- 
tions, 51. 
Reid,  Daniel  G.,  215,  436. 
Reorganization, 

Assessments  for  cash,  417-419. 

Atchison,  Topeka  &  Santa  F6  R. 
R.  Co.,  425-434. 

Capitalization  in,  422-424. 

Cash  requirements,  416-417. 

Committees,  410-412. 

Fixed  charges  reduced,  420-422. 

Foreclosure,  412-413. 

Problems  of,  413-416. 

Reasons  for,  408-410. 

Rock  Island  Co.,  437-440. 

Summary,  424. 

Westinghouse  Co.,  440-443. 
Report    of    Industrial    Commission, 

175-177. 
Revaluation  of  fixed  assets,  327. 


"Right,"    341,   342,   343,    344,   345- 

347. 
Rights  of  creditors,  44. 
Rights  of  stockholders,  37-38. 
Rock  Island  Co.,  437-438,  439,  440. 
Rock  Island  System, 

Growth,  434-437. 

Reorganization,  437-440. 
Roosevelt,  Theodore,  57. 


S 


St.   Louis   &  San   Francisco  R.  R. 

Co.,  409,  427,  430,  433,  440. 
Salaries,   manipulation   of,   by   oflS- 

cers,  352-353. 
Sale  of  old  stock,  345. 
Sale  of  rights,  343-345. 
Sample  by-laws,  29-33. 
Sample  charter,  22-24. 
Saving  from  income,  327-328. 
Schwab,  Charles  M.,  216,  217. 
Securities, 
Banking  house  methods  of  selling, 

231-232. 
Buying  on  margin,  246-247. 
Listing,  240-242. 
Methods  of  selling,  223-224,  235- 

238. 
Requirements  of  banking  houses. 


i 


Selling  short,  247-248. 

Selling  above  par  to  obtain  sur- 
plus, 327. 
Short  selling,  342-343. 
South  Dakota,  corporation  laws  of, 

53,  54,  5"^. 
Southern  Kansas  R.  R.  Co.,  427. 
Southern  Pacific  R.  R.  Co.,  426. 
Speculation, 

Definition  of,  96-97. 

Importance  of,  245-246. 
Speyer  &  Co.,  265. 
Standard  Oil  Co.,  291. 

Lack    of    publicity    of    accounts, 
42. 

Organization  of,  87-92. 

Surplus  of,  328-329. 


INDEX 


479 


State  constitution,  18-19. 
Stimulation  of  speculative  Interest, 

251,253. 
Stock, 

Buying,  340-341. 

Certificates  of,  65-68. 

Common,  71. 

Form  of  certificate  of,  70. 

Nature  of,  33-34. 

Par  vs.  market  value  of,  68-71. 

Preferred,  "cumulative,"  72. 

Preferred,  nature  of,  71-73. 

Preferred,  "non-cumulative,"  72. 

Preferred,  uses  of,  73-75. 

Watering,  347,  349. 
Stock  corporations,  2. 
Stock  Exchange,  239-^40. 

Methods  of,  243-245. 

Volume  of  business,  245. 
Stockholders, 

Attitude  towards   betterment  ex- 
penses, 314-316. 

Liability  of,  42-44. 

Meetings  of,  34. 

Surplus  belongs  to,  333-334. 
Stock  market  manipulation,  254-255. 
Stock  market,  251. 
Subscription  contract,  63. 
Subscription  privilege,  339. 
Surplus, 

Advantages  of  cash,  331-332. 

Cunard  Co.  policy,  332. 

Definition  of,  325-326. 

Disadvantages  of  keeping  in  cash, 
332-333. 

Distribution  of,  380-381. 

Distribution  through  stock-water- 
ing, 337-339. 

Distribution  through   subscription 
privileges,  339-340. 
Sale  of  old  stock,  343. 
Sale  of  rights,  343-344. 
"Short  selling,"  342-343. 
Subsequent  sale,  341-342. 

Effect  on  assets,  335-337. 

Effect  on  dividends,  335-337. 

Fixed  assets  as  a  form  of,  327. 

Functions  of,  331. 


Hamburg-American     Co.     policy, 

332. 
Investment  of,  339-342. 
Obtained  by  inheritance,  326. 
Policy  of  trusts,  329-330. 
Rainy  day  fund  theory,  330-333. 
Revaluation  of  assets  as  a  source 

of,  327. 
Saving  from  income  as  a  source 

of,  327-329. 
Sources  of,  326-329. 
Uses  of,  333-334. 
Syndicate  operations,  253-254. 


Taney,  Chief  Justice,  60. 
Taxes,  302-303. 
Thompson,  Seymour  D.,  350. 
Transfer  of  stock,  34. 
Transferability  of  corporate  owner- 
ship, 10-11. 
"Trust  Finance,"  84,  132,  204,  331. 
Trusts,  83. 

Surplus  of,  329-330. 

U 

Underwriting, 

Advantages  to  buyers,  258-259. 

Advantages  to   corporation,   257- 
259. 

Origin  of,  256-257. 

When  advisable,  259-262. 
Underwriting  houses,  267-268. 
Underwriting  syndicates. 

Characteristics  of,  277-278. 

Distributing     securities     through, 
265-267. 

Example    of    speculative    dealing 
by,  280-282. 

Formal  agreement  of,  269-277. 

Functions  of,  278. 

Handling  speculative  issues,  279- 


Informal  agreements  of. 
Pool  sale  through,  265. 
Types  of,  263-264. 
Why  formed,  262-263. 


480 


INDEX 


Union  Bag  and  Paper  Co.,  320-321. 
Union   Pacific   R.    R.   Co.,  40,  129, 

151,  409. 
U.  S.  Leather  Co.,  100,  101,  107. 
U.   S.    Steel  Corporation,  291,  337, 

436. 
Additional  companies,  211-212. 
Basis  of  capitalization,  215-218. 
Capitalization   at  beginning,  209- 

211. 
Conditions  before  formation,  199- 

205. 
Cost  of  charter,  54. 
Earlier   steel   consolidations,  200- 

201. 
Financial  changes  in,  113-115. 
Formation  of,  194. 
Method  of  promotion,  207-210. 
Number  of  stockholders,  7. 
Operating  policy,  218-219. 
Profits  of  promoters,  209. 
Prospectus  of,  206-209. 
Record  of  earnings,  217. 
Securities  of,  220-222. 
Standing  committees  of,  46. 
Syndicate  agreement,  270-277. 


Value  of  assets,  395-396. 
Vanderbilt,  Commodore,  357. 
Volume  of  sales,  305. 
Voting,  cumulative,  75-77. 
Voting  trusts,  77-78. 

W 
Wabash  R.  R.  Co.,  145. 
Wages,   305. 
Wall   Street,   343. 
Wall  Street  Journal,  367,  391,  397. 
Wall     Street     speculators,     classes, 

250-251. 
Wells  Fargo  Express  Co.,  315-316. 
Westinghouse  Electric  &  Manufac- 
turing Co.,  440-443. 
Western  Union  Tel.  Co.,  129. 
West  Virginia,  corporation  laws  of, 

54-57. 
Woodlock,  Thomas  F.,  303. 
Working  capital,  400-401. 
Forms  of,  289-290. 
Importance  of,  284,  296. 
Practice   of   Pennsylvania   R.   R. 
Co.,  294-^95. 


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